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As a small business owner, you’re probably already measuring the overall financial health of your business. Monitoring inventory, counting the cash drawer, and keeping daily tabs on sales are effective ways to measure profitability and discover new growth opportunities. But even brisk sales, sold-out product lines or stacks of signed client contracts don’t always equal financial stability.

To truly gauge your company’s health, it’s best to look at two aspects of your company’s finances: cash flow and working capital. You probably know how critical cash flow is because you see those numbers on balance sheets after the close of business. But understanding and measuring working capital is important, too.

Together, cash flow and working capital provide an excellent snapshot of your company’s health — its current needs, growth potential and sustainability. However, since working capital and cash flow seem to measure and indicate similar things, some entrepreneurs mistakenly assume they’re interchangeable. They’re not.

What is Cash Flow?

Simply put, cash flow refers to the amount of cash that moves in and out of your company during a specific time frame — how much your business is earning versus how much you’re paying to stay in business (in overhead, to vendors, etc.). Ideally, your cash flow is positive, which means you’re earning more money than you’re paying out during a specified period. Naturally, negative cash flow means your business is spending more money than it’s bringing in. A few months of negative cash flow won’t necessarily ruin your business, but you should be aware if you’re experiencing this and have a strategy in place for moving cash flow back into the positive column.

There are several ways to measure cash flow, whether you want a simple snapshot or a wide-angle picture of your financial situation. Many businesses use an online tool to measure it. Steps you can take that could help increase cash flow include reducing operating costs, selling an asset or more swiftly collecting accounts payable. Some businesses employ a combination of these and other approaches.

What is Working Capital?

Your company’s working capital is the difference between its current assets and its liabilities or debts. Assets are either cash on hand or financial instruments, including investments and bonds, as well as anything that can be liquidated for cash, such as office or business equipment or inventory. Liabilities or debts include loans, outstanding accounts payable and accrued expenses.

Working capital is usually a measurable forecast over a short term, the next 12 months in most cases. Essentially, it measures how readily your business could withstand an unforeseen drop in sales or an unanticipated disruption in your market. Recent weather events and supply chain issues, for example, have demonstrated how volatile today’s market can be for businesses of all sizes in just about every sector.

Businesses with a healthy working capital ratio of assets to liabilities are more likely to withstand these disruptions to stay in business. Whenever possible, it’s best to keep this working capital ratio higher than 1-to-1. Another reason to keep this top of mind is that lenders will look closely at your working capital, and that amount could influence how they view your company’s financial health. 

The primary difference? As you’ve probably discovered, working capital gives you a snapshot of your company’s current financial health — insight about how quickly your company can withstand unforeseen market disruptions. Cash flow is more forward-looking, showing how much cash your business generates over a specific period. Your working capital can (and usually will) fluctuate, but it’s not a measurement you’d use to make projections about your company’s future solvency.

Think of them as different lenses through which to view your business: Cash flow gives you the big picture of your cash intake and outlays while working capital focuses on your company’s ability to withstand unanticipated yet constant market tumult.

Naturally, there are exceptions. For instance, a company that’s generated high revenues while also carrying high levels of debt might have positive cash flow, but very little working capital. Conversely, a new business may have a large amount of working capital (through an initial investment or funding, for example) but is so new that it hasn’t yet generated either positive or negative cash flow.

How Working Capital Impacts Cash Flow

Changes in working capital are reflected in a firm’s cash flow statement. Here are some examples of how cash and working capital can be impacted.

Read Also: The Importance of Working Capital Management: Why it Matters for Businesses of All Sizes

If a transaction increases current assets and current liabilities by the same amount, there would be no change in working capital. For example, if a company received cash from short-term debt to be paid in 60 days, there would be an increase in the cash flow statement; however, there would be no increase in working capital because the proceeds from the loan would be a current asset or cash, and the note payable would be a current liability since it’s a short-term loan. 

  • If a company purchased a fixed asset such as a building, the company’s cash flow would decrease. The company’s working capital would also decrease since the cash portion of current assets would be reduced, but current liabilities would remain unchanged because it would be long-term debt. 
  • Conversely, selling a fixed asset would boost cash flow and working capital.
  • If a company purchased inventory with cash, there would be no change in working capital because inventory and cash are both current assets; however, cash flow would be reduced by inventory purchases. 

Example of Working Capital and Cash Flow

Below is Exxon Mobil’s (XOM) balance sheet from the company’s annual report for 2022. We can see current assets of $97.6 billion and current liabilities of $69 billion.3

  • Cash and cash equivalents is $29.6 billion, and materials and supplies is $4 billion.
  • If Exxon decided to spend an additional $3 billion to purchase inventory, cash would be reduced by $3 billion, but materials and supplies would be increased by $3 billion to $7 billion.
  • There would be no change in working capital, but operating cash flow would decrease by $3 billion.3
ExxonMobil Balance Sheet 2022

Imagine if Exxon borrowed an additional $20 billion in long-term debt, boosting the current amount of $40.6 billion to $60.6 billion. Cash flow would increase by $20 billion. Working capital would also increase by $20 billion. The amount would be added to current assets without any debt added to current liabilities; since current liabilities are short-term, one year or less, and the $40.6 billion in debt is long-term.

How to Improve Your Cash Flow and Working Capital Management

1. Understand that cash is king

“Cash flow is the ultimate value driver,” says Jack. Any business, regardless of its niche, needs sufficient cash at all times in order to run effectively. That’s why your cash flow statement is at the heart of your company’s financial reporting.

Recognizing the importance of cash flow is imperative to improving your finance team’s reporting processes. Remember, preparing your cash flow statement isn’t just another finance drill; it’s a key insight into your company’s performance and where it stands financially.

2. Improve your indirect cash flow reporting

The indirect method of cash flow reporting starts by presenting cash flow with net income or loss before adding or subtracting non-cash revenue and other expenses. “It’s a rather ugly yet necessary form of presenting cash flow,” says Jack. “It’s actually what’s required by the public reporting entities in the US.”

The indirect method is often used in external communications to report a company’s cash flow to banks and investors. It’s also commonly used in financial models like annual plans, long-term projections, and company valuations.

Unfortunately, the indirect method has some drawbacks.

“It doesn’t provide a lot of value in understanding a company’s cash flow or how to improve it, and that’s mainly attributable to the fact that it offers no insight into any major drivers,” says Jack. “It’s also almost incomprehensible for non-finance people, and many finance folks as well.”

In his webinar, Jack shared some tips for improving your indirect cash flow statements by tracking key metrics like DSO, DSI, accounts payable, capital expenditures, depreciation estimates, and more.

3. Create a cash budget (aka direct cash flow statement)

The direct method of cash flow reporting offers much more intuitive insight into a company’s cash flow. It works by looking directly at the in and outflow of a company’s cash and provides insight into its major cash drivers, including customer receipts, payroll, and payments to suppliers.

“The direct method also allows us to focus on the specific timing of inflows and outflows of cash over the next couple of months and summarizes everything in an ending cash balance,” says Jack.

This method is generally used by cash managers, but companies can and should also use it for a more intuitive look at their flow of cash.

Tips for better working capital management

Working capital is another key metric tracking a company’s financial standing. “I have found that almost every enterprise can evoke substantial reductions in working capital management by going through a progressive review of its processes,” says Jack. Below are some of his top tips your company can use to improve its working capital management.

4. Run a critical analysis of your accounts receivable

Accounts receivable is one of the biggest assets on any balance sheet. “It’s also a great reflection of customer satisfaction, the quality of our goods and services, and the credit status/worthiness of our customers,” says Jack.

To review your accounts receivable, you’ll want to start by working out your best possible DSO and comparing that to your current average. Then, you’ll want to identify the key reasons why your DSOs aren’t where they could be.

To identify what’s driving your accounts receivable, you’ll want to look at some key drivers of the revenue process, including:

  • Your credit policies.
  • The financial health of your customers.
  • The quality of your products and customer service.
  • The efficiency of your collections management and your entire revenue cycle.
  • Shipment patterns.

In his webinar, Jack outlines a detailed process for reviewing your accounts receivable by looking at key drivers starting at the sales process right down to the final day when you receive payment. If, for example, your accounts receivable are simply driven by payment lags from your customers, you can address this by improving your customer service process.

“Rather than waiting 45 days to call a customer, call them on day 15. Then you’ve started the clock and removed any possible excuses for outstanding payments,” says Jack.

5. Review your supply chain and inventory

Supply chain and inventory are a key asset in almost every industry except the service sector. According to Jack, one of the keys to creating better supply chain and inventory processes is expanding the scope of inventory to include customers and returns and, prior to that, product conception/development, sales forecast, and planning.

“One of the first things I like to do when analyzing inventory is to create a value-focused report that lists inventory in descending order based on value,” says Jack. From there, you should start reviewing your inventory by focusing on the top 20%.

Remember, if you’re going to move the needle, it’s best to start with the large items. “Pareto analysis is a very effective yet often under-used tool here,” says Jack.

Another key area to look at when reviewing your company’s supply chain and inventory is excess and obsolete inventory. This typically makes up a large component of inventory and also indicates a number of process failures.

Some root causes of excess and obsolete inventory, for example, include poor product management and sales forecasting.

“Some old school tools like variance analysis, roll forward, and trend schedules can provide a lot of insight into the dynamics of your company’s inventory,” says Jack.

6. Generate cash by monetizing non-strategic assets

Last but not least, one of Jack’s final tips for how you can improve your cash flow and working capital is simple; monetizing non-strategic assets.

“I’ve found, for example, that a lot of organizations have an excess of unused real estate,” says Jack. Renting out or selling these spaces can help generate cash for a company, as can;

  • Licensing specific technologies to other markets.
  • Divesting non-strategic product lines.
  • Liquidating investments in partnerships and venture funds.

What are the 4 Components of Working Capital?

Working capital is an important measure of a company’s short-term financial health. It gives insight into a company’s ability to satisfy its immediate responsibilities. Working capital, which is made up of several components, is an important measure that must be carefully managed to ensure long-term performance.

Below, we will look at the many components of working capital and discuss ways to manage it more effectively.

1. Cash and cash equivalents:

Cash and cash equivalents refer to the readily available funds held by a company. For example, let’s consider a retail business. The cash in the register, the money in the company’s bank account, and short-term investments such as highly liquid stocks or government bonds all fall under this component.

Having cash on hand allows the business to cover daily expenses, pay employees, and handle unexpected costs efficiently.

2. Accounts receivable:

Accounts receivable represents the amount of money owed to a company by its customers for products or services already delivered. Let’s say a manufacturing company sells its products on credit terms to its clients. The outstanding invoices that are yet to be paid by the customers make up the accounts receivable component.

Efficient management of accounts receivable involves timely invoicing, diligent follow-ups, and implementing a systematic collection process.

3. Inventory:

Inventory comprises the value of goods held by a company that are ready to be sold. For instance, consider a grocery store. The products stocked on the shelves, including food items, household supplies, and other merchandise, constitute the inventory.

Proper inventory management is crucial to avoid overstocking or stockouts. It involves monitoring demand, optimizing procurement, and implementing effective inventory control systems.

4. Accounts payable:

Accounts payable denotes the amount a company owes to its suppliers for goods or services received. Let’s imagine a restaurant that purchases ingredients from various suppliers. The unpaid bills for these supplies make up the accounts payable. Managing accounts payable involves negotiating favorable payment terms with suppliers, ensuring timely payments, and maintaining strong relationships to secure discounts and favorable credit terms.

5. Optimizing Working Capital Management:

  • Regularly Track Working Capital:

Monitoring your working capital balance is critical to identifying any potential issues early on. Regularly analyze the components of working capital to identify trends, anomalies, and areas for improvement.

  • Maintain A Healthy Cash Flow:

Strong cash flow management is essential for effective working capital management. Generate sufficient cash from daily operations to cover expenses, repay debts, and invest in growth initiatives. Implement cash flow forecasting and budgeting to anticipate potential shortfalls or surpluses.

  • Streamline Accounts Receivable:

Implement efficient invoicing and collections processes to minimize outstanding receivables. Offer incentives for prompt payments, provide convenient payment methods, and establish clear credit terms. Regularly review credit policies to strike a balance between customer satisfaction and minimizing late payments.

  • Optimize Inventory Management:

Employ inventory forecasting techniques to align stock levels with customer demand. Identify slow-moving or obsolete items and implement strategies such as discounts or promotions to accelerate sales. Explore just-in-time inventory systems to reduce carrying costs and enhance liquidity.

  • Negotiate Favorable Terms With Suppliers:

Collaborate closely with suppliers to negotiate longer payment terms without straining relationships. Extend payment terms strategically to align with the cash conversion cycle, ensuring that accounts payable do not impede working capital efficiency.

Conclusion

Effectively managing working capital is crucial for the short-term financial health of any business. By understanding the components of working capital—cash and cash equivalents, accounts receivable, inventory, and accounts payable—companies can make informed decisions to optimize their working capital management.

Regular tracking, strong cash flow management, streamlined accounts receivable processes, optimized inventory levels, and strategic supplier negotiations are key strategies for maintaining a healthy working capital balance. With diligent management of working capital, businesses can ensure financial stability and position themselves for long-term success.

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