Working Capital Management: What It Is & Why It’s Important
One of the strongest indicators as to the health of a company is its access to working capital and how it manages said capital. The best way to understand how working capital is determined is to know that it’s the difference between your company’s available assets and its liabilities. Basically, you’re talking about cash that is currently available to your business, unpaid invoices, and any existing inventory compared to your current accounts payable and money your business might owe. That seems simple enough, but how do each of these different elements come together to form the basis of working capital management?
Understanding the Three Keys of Working Capital Management
Before we get too deep into the weeds on working capital management, it’s important that you have a nuts and bolts understanding of exactly what constitutes working capital. Working capital management traditionally consists of three key features. Each of these components is equally important in determining the financial health of your business.
1. Accounts Receivable
First, you need to look at your accounts receivable. This is all of the money that is currently due to your company. Any services or goods you’ve already provided that you are expecting payment for can be considered as part of your accounts receivable. That means your accounts receivable also include any outstanding invoices you’ve sent to clients or customers that they’ve agreed to pay but haven’t gotten around to yet.
What’s most important about your accounts receivable is that they represent incoming cash flow. Good or services for which you’ve already invoiced can prove to be valuable collateral against which your company can borrow money to cover any potential cash flow gaps. While it can seem like cold comfort when your business is trying to keep the lights on, knowing that you have incoming cash flow on the books can prove a deciding factor in getting the funding you need.
2. Accounts Payable
Once you have established your existing accounts receivable, it’s time to look at your accounts payable. Your accounts payable are practically the opposite of your accounts receivable. These are any bills or other monies that your company is required to pay in the short term. You’ll often see companies seeking to delay accounts payable as long as they can (within reason) so they can maximize the amount of available positive cash flow.
A result of this practice can be seen in the forms of what are known as “net” payment terms — such as net-30, net-60, and so on. While these net terms can be beneficial for large companies in the short term, they’ve also created a ripple effect throughout all kinds of industries where small and medium-sized businesses (SMBs) are put in tough positions where their cash flow is hindered as a result of these terms.
3. Assets and Inventory
It’s also important to make sure you keep track of every asset belonging to your company. Any inventory your company currently has on hand is considered a positive asset. This is assuming that any inventory you have on hand is going to be sold and converted into capital.
Of course, inventory can be a tightrope for companies to maneuver. How a business manages its inventory can be a strong indicator of the overall operational efficiency of your business. It’s crucial that your company has enough inventory on hand to fulfill any potential orders, but not so much that you have an inordinate amount of working capital tied up in your inventory.
How your business handles these three vital components is the backbone of what makes up working capital management. Now that you know what working capital management is, it’s imperative to understand why it’s so important.
Why Working Capital Management is Important for Your Business
We need to establish why working capital management is much more than business jargon. Working capital management is essential to the success of your business and how your business is viewed by others.
The ability to properly manage working capital directly correlates to the growth of your business, not to mention its overall operational viability. Managing your working capital is about more than keeping cash on hand and having a financially solvent company. It’s about how you’re using that money and if you have the business acumen necessary to capitalize on your assets.
Sound working capital management means ensuring that your business maintains an adequate cash flow on hand. This cash needs to be able to satisfy any and all operating costs for the short term in addition to any bills or other obligations. That’s on top of using your capital to maximize profits and continue to grow as a company.
Understanding Your Working Capital Ratio and Where it Needs to Be
The amount of working capital you have compared to your existing obligations makes up your working capital ratio. The formula for your working capital ratio is that you take your existing assets and divide them by any liabilities you might have.
This ratio is a key metric in establishing the financial health of your company. A ratio of less than 1.0 may indicate that your company is unable to meet its short-term debts and might be dealing with liquidity issues later on. This is also a tell-tale sign of a business experiencing cash flow gaps.
On the other hand, if your working capital ratio is too high, it might mean you don’t know how to take advantage of an opportunity. If your working capital ratio is higher than 2.0, it may reflect that you don’t know how to make the best use of your assets to invest back into the business and continue to grow your company while increasing revenue.
The “goldilocks” zone of where you want your working capital ratio to lie tends to fall in between 1.5 and 2.0. This tells people that your business is financially solvent with plenty of cash on hand, but is still taking proactive steps as it pursues future growth.
How to Turn Accounts Receivable Into Working Capital
We’ve established how you can define working capital management. You also understand why properly managing your working capital is important for your business. Now that we have that out of the way, what can SMBs do to create more working capital in a world where it seems like everyone is trying to delay payments for as long as possible?
As we covered above, existing invoices are a key component of your accounts receivable. We also mentioned how these invoices can be relied upon as a form of collateral in securing additional working capital for your business. This is where invoice financing and invoice factoring come in.
Invoice Financing Creates Working Capital from Existing Invoices
While net terms can be convenient for large businesses looking to manage their working capital, they can quickly become unfair to the small and medium-sized businesses relying on these payments to keep their businesses afloat.
Invoice financing provides a much-needed lifeline for SMBs looking to get a firm grasp on their working capital management and allow for the cash flow they need to keep debt obligations paid and everything else running smoothly.
Alternative lending is gaining traction among small businesses thanks to its more relaxed qualifications, convenience, and fast access to capital. When SMBs are able to have up to 100 percent of their outstanding invoices advanced to them in as little as 24 hours, it’s not hard to see why. As long as a business has documented its outstanding invoices, it can reach out through online invoice financing to secure the working capital it needs to continue to operate at a higher standard.
Securing the Capital Your Business is Owed
It’s hard to talk about working capital management without having the cash flow to manage. Thanks to alternative lending services such as online invoice financing, businesses are no longer held hostage by one-sided net payment terms that only serve to benefit large companies.
Through access to more working capital on a faster timeline thanks to invoice financing and invoice factoring, SMBs are able to proactively manage this capital to further grow their business. Rather than wait for months on end to be paid for services rendered or goods you’ve already produced, a business can receive the money it’s owed on time and focus on running their business, rather than tracking down customers for payment.
Make Working Capital Management Work for You
Ultimately, working capital management is a hallmark of every well-run company. What’s most important is how your business goes about managing that working capital and having access to that money in the first place. FundThrough offers valuable invoice financing options for small and medium-sized businesses ready to take things to the next level. Are you prepared to unleash your working capital? Learn more about how invoice financing is a possible solution to providing your business with the working capital you need to succeed.
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