Key Steps for Managing Working Capital: Ultimate Guide
A company's financial success is often measured by its working capital. Therefore, it is important to understand what this metric is and how it can successfully be managed.Surprising or not, profit is not the sole indicator of a business’s viability. For example, many companies go bankrupt not because of low revenue streams but because their liabilities outweigh their current assets.
Many investors evaluate a company’s health based on its working capital management. Therefore, every small business should pay close attention and invest time and resources to maintain this metric.
What Is Working Capital?
Working capital (WC) is the difference between current assets and liabilities. But that’s just scratching the surface. There is a lot more to unpack to fully understand what this term means. Let’s dive a little deeper.
Working Capital Definition
A positive WC indicates that the company can pay off its outstanding debts using its assets. Conversely, a negative number shows that the company is unable to meet its short-term obligations. For instance, a company may have total current assets worth $500,000 and liabilities worth $600,000. Since the liabilities outweigh the company’s assets, it would translate to negative WC, meaning they are unlikely to cover their debts.
Positive WC is a solid way of attracting investors to your business. Solvency is usually a more important indicator for investing than profitability. For instance, a company may generate positive income for the third year in a row, but its short-term debts can outweigh its combined assets. As a result, a potential investor may avoid investing in the business because its outstanding debt outweighs consistently high profits.
What Is Working Capital Management?
Working capital management refers to monitoring the WC of the company. Management oversees that the company operates efficiently and maintains sufficient capital to meet its short-term obligations, such as loans, wages, accounts payable, lease payments, and taxes.
WC management includes inventory management, cash flow management, and the management of receivables and payables. It can create a plan to use your resources wisely and remain solvent.
Working Capital Management Example
Suppose Company A has $100,000 in cash, $50,000 in accounts receivable, and another $50,000 in inventory. It also has a short-term debt of $300,000 that it needs to pay in less than 12 months. Thus, the company’s current assets are equal to $200,000, and the current liabilities are $300,000. If we subtract the total liabilities from the assets, working capital would be equal to negative $100,000. A negative balance suggests that the company doesn’t have enough funds to pay its short-term obligations.
Working capital management would work towards improving this number. It would make sure the company has sufficient capital for its daily operations. There are five fundamental problems it would try to solve:
- How to increase the cash volume
- How to collect receivables on time
- How to repay the creditors on time
- What is the right amount of inventory to keep
- Where to look for short-term financing
There are five steps that every company can implement to efficiently and effectively manage their working capital.
Steps for Effective Working Capital Management
Pay Attention to KPIs
Healthy working capital is the responsibility of everyone in a company. Establishing and following certain key performance indicators (KPI) are crucial for long-term stability and solvency. As a manager, you need to assess these indicators monthly to track performance. We suggest using the following KPIs as cornerstones of your working capital management:
- Current Ratio - assets divided by liabilities. The current ratio shows the company’s liquidity. A current ratio higher than one means that the company has sufficient cash to cover its liabilities. Conversely, a number lower than zero signifies the insufficiency of funds to do so.
- Quick Ratio - cash and receivables divided by current liabilities. Unlike the current ratio, the quick ratio considers only two of the most liquid assets - cash on hand and accounts receivable. If the quick ratio is higher than one, the business is liquid enough to repay its short-term obligations. For example, if a company has cash and receivables totaling $200,000 and liabilities of $150,000, their current ratio will be 1.3. This means that the company is solvent.
- Cash Conversion Cycle (CCC) - indicates the amount of time needed for converting all current assets into cash. The metric can be calculated using the following components:
- Days Sales Outstanding (DSO) - average time needed for customers to pay their invoices.
- Days Inventory Outstanding (DIO) - average time needed for the company to sell its inventory.
- Days Payables Outstanding (DPO) - average time needed for the company to pay its suppliers.
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 abovementioned metrics are universal for all businesses to use regardless of their type of company. For example, a cash conversion cycle is a crucial metric that shows the condition of your working capital. The lower the time period, the faster you can turn your assets into cash and pay off your creditors.
Pay Vendors on Time and Follow Up with Debtors
At first glance, it may seem that the later you pay your suppliers, the better your cash collection cycle will look. However, never consider delaying your obligations for the sake of better working capital. Sooner or later, you will have to pay your debts if you don’t want to go bankrupt and face problems like stress.
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 too. For example, you can turn to alternative lending solutions.
One alternative lending solution is invoice financing. This method involves selling your unpaid invoices to a creditor, paying 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 is meant to incentivize the debtor to repay the outstanding balance quickly by providing them a sale price on items.
Convert to Electronic Payables and Receivables
At times, delays in payments can be caused by inefficient cash collection systems. Printable invoices can get delayed or lost and create natural delays. A solution to this problem is converting from paper to electronic invoices and keeping a digital database of paid and unpaid checks. Global Newswire reports that small and medium-sized businesses can save up to 75% if they automate their accounts payable and receivable processes.
Electronic payments can now be made in a couple of seconds, which eliminates transaction times significantly. This can remarkably shorten the receivables periods 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.
Reduce Inventory Levels
Another trick you can use to minimize your cash collection cycle is to keep your inventory levels as low as possible. As a small or medium-sized business, you need to optimize your inventory levels to never face shortages or stockpiling. Maintaining inventory is costly, and unless you use the mass production strategy, your inventory levels can tell you a lot about your WC.
Adopting the just-in-time inventory management ideology can help improve your working capital. This philosophy suggests producing equal to the demand for a given time period. 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 the amount of 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 some space in the formula 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 materials delivery can cause a delay in the final product if you don’t have some emergency supplies saved up.
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, Burberry had to dispose of $37 million worth of inventory because of its inability to sell. This led to a significant decline in Burberry’s working capital for the following year.
Receive Adequate Financing
Last but not least, it’s crucial to also manage the current liabilities part of the equation. Analyzing your KPIs can help you determine the right amount of financing you need for supplier and operation costs. Be careful not to take more money than you can repay. Otherwise, your working capital can take a severe downturn.
Using your own equity to invest in your business has its advantages, of course, operating a reliable investing strategy. When you invest your own funds, you generally have higher control over your spending. However, believe it or not, taking a loan to finance your operations can be a viable idea when your business is doing well. Instead of lowering the number of your current assets, you can take long-term business loans. You may gain access to extra cash for operating expenses, which you can pay back over the years.
We again draw your attention to alternative financing solutions. 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 the funding in just a couple of days.
Bottom Line
These key steps can help improve your working capital management to achieve long-term success. You should always aim to keep enough cash to pay your short-term debts. If you don't have enough 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.
