Contrary to popular belief, profit is only one indicator of a business’s viability. Investors often evaluate a company’s health based on its working capital, and therefore every small business should pay close attention and invest time and resources to maintain this financial metric.
Let’s take a look at the intricacies of managing working capital and how it can help your business thrive.
Working capital (WC) is the difference between current assets and liabilities. Calculating working capital helps businesses understand how viable their financial structure is.
Assets can include cash, inventory, accounts receivable, stocks and bonds, and inventory. Typically, when measuring WC, assets will include anything that can quickly be converted into liquid cash. Conversely, liabilities refer to financial obligations, such as accounts payable, debt repayments, and unearned income.
Working capital influences the operational limits of a company and can be used to determine how financially sound a company is. For instance, a positive WC indicates that the company can pay off its outstanding debts using its assets. Conversely, a negative WC shows that the company cannot meet its short-term financial obligations.
Suppose Company A has $100,000 in cash, $50,000 in accounts receivable, another $50,000 in inventory, and a short-term debt of $300,000 that it needs to pay in less than 12 months.
The company’s current assets would equal: $100,000 + $50,000 +$50,000 = $200,000
The company’s liabilities would include the $300,000 in short-term debt. To get working capital, we subtract liabilities from assets:
WC = $200,000 - $300,000
The working capital Company A is left with is -$100,000. A negative balance suggests that the company may not have enough funds to pay its short-term obligations.
While working capital can be used company-wide, it can also be divided and calculated for individual assets and liabilities within the larger company structure. Read on to discover the different types of working capital.
Permanent working capital, also known as fixed working capital, refers to the amount of capital necessary to keep a business afloat. Permanent working capital varies from business to business and can be influenced by company size, business model, and product or service.
Permanent working capital encompasses:
Variable working capital, or fluctuating working capital, indicates any capital that changes based on external factors. Variable working capital can be divided into two categories:
Gross WC represents the company’s assets only and doesn’t account for any liabilities. The assets accounted for can include cash, accounts receivable, inventory, investments, and other assets that can be easily liquidated.
Simply put, gross WC reveals how much spending money a company has. However, it does not account for liabilities and thus isn't effective at determining financial stability or operational efficiency. Instead, gross WC helps determine a company’s raw, liquid value.
Net working capital is the cumulative balance of every asset and liability of a company. Net WC can be used to determine the stability of a company’s general finances and aid in planning company growth. Net working capital can have a positive, negative, or neutral direction.
Positive net WC indicates that your assets outweigh your liabilities. Positive net WC is financially more secure than neutral or negative WC as it shows that a company has enough assets to liquidate in case of emergency. If companies have a positive net WC, they may be able to use it as a leverage point when seeking investors because of how it proves company stability.
Negative net working capital means that your liabilities outweigh your assets. This can threaten a company’s viability if the debt is continually being accrued and the company does not have the assets to manage those debts effectively. Negative WC can also limit a company’s ability to expand or grow if it constantly allocates most of its assets to debt management.
However, negative working capital is not always cause for alarm. Many companies successfully operate with little working capital due to a low-cost, quantitative business model. This means the company has high expenses but is making enough revenue to compensate.
A neutral net working capital indicates a balance between liabilities and assets. Depending on the business’s focus, this model can either be a harmonious balance or a rocky foundation. Neutral capital can signify that a company operates within its means while maximizing its growth potential. However, a business with less of a financial buffer can risk falling into debt if its liabilities increase.
Working capital management refers to the budgeting and monitoring of a company’s assets and liabilities. Managing your working capital ensures your company operates efficiently and maintains sufficient capital to meet its short-term obligations.
Such obligations include loans, wages, accounts payable, lease payments, and taxes. Additionally, WC management includes inventory management, cash flow management, and the management of receivables and payables. Each of these is commonly viewed independently, but WC management encompasses each of these moving parts and determines the impact on the overall structure of your business.
Managing your working capital can provide a healthy foundation for your business plans. Here are some of the ways that managing working capital can be beneficial to your business:
Effective WC management accounts for all the moving variables of running a business while also keeping an eye on the horizon for potential changes to the economic climate. With so many moving parts, it can take time and practice to determine the most important factors to monitor.
So, here are five steps that every company can implement to efficiently and effectively manage their working capital.
Healthy working capital is the responsibility of everyone in a company. Establishing and following certain key performance indicators (KPI) is crucial for long-term stability and solvency. Managers are responsible for assessing these indicators monthly to track performance.
We suggest using the following KPIs as cornerstones of your working capital management:
The CCC can be calculated through this formula:
CCC = DIO + DSO - DPO
Different companies can create and use their own KPIs depending on their industry or sectors. However, the aforementioned metrics are universal for all businesses regardless of vertical.
It may seem that the later you pay your suppliers, the better your cash collection cycle will look. However, delaying your obligations for the sake of better working capital is more likely to raise stress and risk. Sooner or later, you will have to pay your debts if you want to stay afloat and grow your business.
Primarily, you can focus on collecting your receivables on time. To mitigate late payments, you may decide to impose strict repayment terms and limits on debtors. You may also opt to conduct business with high credit holders as a safeguard against late receivables payments.
There are other ways to stimulate more organized cash collection procedures, such as turning to alternative lending solutions. One alternative lending solution is accounts receivable financing. This method involves selling your unpaid invoices to a creditor, who will pay you a portion of your receivables upfront. In turn, your debtors will repay their invoices to the creditor directly, and you may be charged a fee per paid invoice.
Dynamic discounting is another alternative that offers debtors a discount on their invoices in exchange for immediate payment. This method incentivizes the debtor to repay the outstanding balance quickly.
Inefficient cash collection systems and printable invoices are most susceptible to being lost or creating payment delays. A solution to this problem is converting from paper to electronic invoices and keeping a digital database of paid and unpaid checks.
Zapier reports that 88% of small and medium-sized businesses experienced faster processes, fewer errors, and better customer support by automating their accounts.
Electronic payments can be made in seconds, significantly eliminating transaction times. This can remarkably shorten the receivables period and accelerate the cash conversion cycle. Moreover, electronic payment systems can send multiple reminders to all parties before payment days and eliminate errors and lost invoices.
Another trick to minimize your cash collection cycle is keeping your inventory levels as low as possible. Small or medium-sized businesses must optimize inventory levels to reduce shortages or stockpiling.
Adopting the just-in-time inventory management ideology can help improve your working capital. The just-in-time inventory operates on a “to-order” basis of creating a product only after a confirmed demand. For example, large companies such as Toyota and Apple will only begin manufacturing certain products once a customer has placed an order.
It is a good idea to avoid excessively stocking up on inventory before actually determining demand. There’s always a risk of not selling the amount you have forecasted. Even though inventory is usually considered a current asset, minimizing it can free up space in the budget and boost your working capital.
Just-in-time inventory systems can save you a lot of time and money. Additionally, it can reduce waste and save warehouse space. However, at times it may be complicated to maintain this model. For example, a delay in raw material delivery can cause a pushback in final production if you don’t have a stock of emergency supplies.
The U.S. Small Business Administration warns that poor inventory management is responsible for most small business shutdowns. Inventory problems can also damage large companies that mass produce their products. For example, Nike’s efforts to sell overproduced inventory resulted in a hit to their profit margin, which in turn caused a drastic slide in Nike stock. Many companies also experienced severe inventory conflicts amid the COVID-19 outbreak and subsequent lockdowns, which delayed global production and thus derailed many companies’ seasonal inventory plans.
Managing current liabilities is crucial, and analyzing your KPIs can help you determine the right amount of financing you need for supplier and operation costs. However, be careful to only take what you can repay. Otherwise, your working capital can take a severe downturn.
Using your own equity to invest in your business can be a reliable investment strategy, as you’ll generally have higher control over your spending. However, believe it or not, taking a small business loan to finance your operations can be viable when your business is doing well.
Instead of lowering the number of your current assets, you can long-term business loans to improve your operating capital. As a result, you may gain access to extra cash for operating expenses, which you can repay over the years.
Unlike traditional funding sources, alternative lenders may offer working capital loans to businesses with lower credit scores. There are many WC loans you can apply for online. These loans aim at helping businesses with their day-to-day operations, such as payroll or rent. Efficient operations, a steady revenue stream, and a detailed financial plan can help a business secure a loan with an alternative lender. In some cases, you can receive funding in just a few days.
These key steps can help improve your working capital management to achieve long-term success. Always aim to keep enough cash to pay your short-term debts.
If you need more cash on hand, make sure that your current assets' cash conversion cycle is sufficient. You can improve it by implementing an optimized inventory management system, collecting your receivables on time, and making your due payments without delays.