The Importance of Working Capital Management
The importance of working capital management to your business cannot be understated. In fact, the management of working capital is one of the strongest indicators of the health of a company. But what is working capital, exactly? In a nutshell, working capital is the difference between your firm’s available assets and its liabilities, and includes things on your balance sheet such as cash, unpaid invoices, existing inventory, current accounts payables, and liabilities. That seems simple enough. But how do each of these different elements come together to form the basis of working capital management?
What Is Working Capital Management?
Working capital is the difference between your company’s current assets—cash, inventory, accounts receivables—and its current liabilities—short-term loans, accrued liabilities, and accounts payables. It must be monitored to ensure a positive cash flow, and when handled correctly, it can improve your company’s profitability. In practice, it deals with the cash conversion cycle-or, how long it takes to turn inventory into sales, receive payment, and pay vendors.
In other words, your company’s working capital is made up of its current assets minus its current liabilities.
Key Takeaways on the Importance Working Capital Management
Working capital management traditionally consists of three key components that can determine your business’ financial health.
1. Accounts receivable
This is all of the money currently owed to your company for any services or goods you’ve already provided and that you are expecting payment for. That means your accounts receivables 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 receivables is that they show whether or not you have sufficient cash flow to meet your debt obligations. A simple cash flow statement can highlight your net working capital.
Invoices can also be used as collateral so that your company can get capital without creating more debt to cover any potential cash crunch. It’s a helpful option to have available because not all companies can meet the credit terms necessary to qualify for a traditional bank loan, which often comes with a lengthy application process.
2. Accounts payable
Your accounts payable are the opposite of your accounts receivable. These are any bills or other funds that your company is required to pay. Some companies delay payments as long as they can (within reason) so they can maximize the amount of available positive cash flow on their balance sheet. Others choose to pay early in hopes of capturing an early payment discount.
It’s not uncommon for companies to see net-30, net-60, or even longer payment terms. Net terms can be beneficial for large companies in the short term. However, they can also create a ripple effect throughout small and medium-sized businesses (SMBs) that are put in a tough position because their own cash flow is hindered as a result of slow payment. As a result, many smaller organizations may turn to short-term financing for vendor payments or inventory management during cash flow gaps.
3. Assets and inventory
Inventory your company currently has on hand is considered a positive asset. This is assuming that any inventory you have will be sold and converted into capital during the cash conversion cycle. How you manage your company’s 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 orders, but not so much that the amount of working capital tied up in your inventory (or its storage) impacts your cash situation.
How business owners handle these three vital components determines how well (or how poorly) they manage their working capital.
How Is Working Capital Management Calculated
Working capital is calculated by taking your current assets divided by your current liabilities. Generally, a current ratio above 1 means your current assets exceed your current liabilities. The higher the ratio, the better.
The calculation looks like this:
Working Capital = Current Assets / Current Liabilities
This formula gives you an idea of the availability of your short-term liquid assets after your short-term liabilities have been paid off. It is a measure of your company’s short-term liquidity and is important for managing cash flow and positive working capital.
The Importance of Working Capital Management
Efficient working capital management is much more than business jargon. Working capital management is important to the success of your business and how others view your business. In other words, are you a well-managed company or a bankruptcy risk?
Proper management of working capital directly correlates to the growth of your business, not to mention its overall operational viability. Positive 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 especially how you’re capitalizing on your assets.
The importance of working capital management done well, means ensuring that your business maintains adequate cash flow required to satisfy any day-to-day operational activities and operating costs for the short term and any bills or other obligations — on top of fueling your business growth
Understanding Your Working Capital Ratio
To recap, the amount of working capital you have compared to your existing obligations or debts makes up your working capital ratio. The formula for your working capital ratio: take your existing assets and divide them by any liabilities you might have.
This ratio is a key metric in establishing your company’s financial health. A ratio of less than 1 may indicate that your company is unable to meet its short-term obligations and debts, and might be dealing with liquidity issues later on. This is also a sign of a business experiencing cash flow gaps and limited cash resources. It’s possible that the business may be struggling with negative working capital, and needs to revamp its cash management strategy.
On the other hand, if your working capital ratio is too high, it might mean you have untapped potential to take advantage of growth opportunities. Suppose your current ratio is higher than 2. In that case, it may reflect that you have the excess cash and capacity to take on big projects or otherwise reinvest into the business and continue to grow your company while increasing revenue.
The “goldilocks” zone is generally where you want your working capital ratio to be. This tends to fall between 1.5 and 2.0. It tells people that your business is financially solvent with plenty of cash on hand, but is still taking proactive steps to positive cash management as it pursues future business growth.
Types of Working Capital Management Ratios
To stay on top of things, there are two more ratios you need to know:
Inventory turnover ratio: You calculate this ratio by dividing the cost of goods sold (COGS) for a certain time period by the average inventory costs for that same period. Because inventories and supply chains can fluctuate over the course of a year, inventory management and knowing your inventory turnover ratio can give you a better grasp on if you’re moving inventory or not moving inventory, which can cause cash flow issues.
Collection ratio: Calculate your collection ratio this way: take the number of days in an accounting period multiplied by the average amount of outstanding accounts receivables. Then divide that by the total amount of net credit sales during that accounting period. The result of the calculation gives you a clear understanding of how efficiently your business handles your accounts receivables and how many days, on average, it takes to receive payment after invoicing.
How to Turn Accounts Receivable Into Working Capital
Proper working capital optimization is important for your business. But what can SMBs do to create more working capital in a world where it seems like all your customers are trying to delay payments for as long as possible? Besides having a clear understanding of the importance of working capital management, of course!
Existing invoices are a key component of your accounts receivables. They can be used as a form of collateral as a means to secure additional working capital for your business and for cash flow forecasting. You already know it can often be difficult to collect on slow-paying invoices. An invoice funding partner like FundThrough can provide capital for your invoices in days.
Invoice Financing Creates Working Capital from Existing Invoices
While extended net payment terms can be convenient for large businesses looking to manage their working capital, they put the small and medium-sized businesses relying on these payments in a bind.
Invoice funding provides a much-needed lifeline for SMBs that want to get a firm grasp on their working capital. Alternative lending is gaining traction among small businesses thanks to its convenient process, flexibility and fast access to capital.
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 factoring, businesses no longer find themselves tied to one-sided net payment terms that benefit large companies.
Rather than wait for months to be paid for services rendered or finished goods 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.
Factors That Affect Working Capital Needs
There are dozens of factors that affect an organization’s working capital requirement. Not all factors relate to all businesses, and how much capital you need at any given time depends on your specific business model.
- The nature of the business — Do you manufacture something and sell to wholesale suppliers? Are you a service business or in the retail industry? What you do impacts working capital.
- The scale of your business — Are you a large or small business? Small and medium-sized businesses in all types of industries often need more working capital to fund growth.
- Seasonal or cyclical business — Are there times when you’re doing booming business and times when there is little work? When you’re busy, you need the working capital to get the job done. When you’re not, you might need it to get through the slower months.
- Operating efficiency — What is the turnaround time from production to sales? Long turnaround times require working capital to sustain the business.
- Availability of materials — If your business depends on specific materials which have limited availability from suppliers, you may need more working capital to get by.
- Potential for growth — If you just won a large contract and need to boost production to meet the job requirements, you may need more working capital. This can be especially true if you have a lot of debt or can’t meet the credit terms for a loan or line of credit from a bank or other financial institution.
- Inflation — Inflation can mean a rise in prices, which means you need working capital to pay the higher price of goods and materials.
What Are the Benefits of Working Capital Management?
Sound financial management — and effective working capital management — can help you maintain a balance and directly impact profitability, liquidity, and growth.
Efficient working capital management helps ensure your business runs smoothly and includes managing your inventory, accounts receivables, and accounts payables.
It also takes maintaining both your short-term assets and liabilities to ensure you have the liquid funds necessary to run your day-to-day operations. That’s because liquidity, or the liquid assets you can easily convert to cash, is typically tight in most small businesses. Many companies cannot easily fund their operations between delivering a product or service and being paid.
A firm grasp on the importance of working capital management becomes imperative if you want to keep the lights on and grow your business.
Make Working Capital Management Work for You
Operating with positive working capital is the only way to grow a business, and to ensure cash flow is always in the black, effective working capital management is key. Most importantly, a business must manage working capital and have access to it on demand.
In designing a plan for working capital improvement, it’s common to turn to short-term financing options.
Learn How Invoice Factoring Works
Invoice factoring is a popular way to improve your working capital cycle. Basically, you sell your unpaid invoices to a third-party (like FundThrough) and get paid in days. The factoring company takes care of the collection process from your clients in a friendly, professional way. Not only do you get flexible extra funds for your working capital needs, but you also save lost time in chasing up late payments.
Are you prepared to unleash the full potential of your working capital? Create a free account now and fund your first invoice.
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