Working capital management involves adjusting a company’s short-term assets and liabilities to ensure that it has sufficient resources to satisfy its immediate financial obligations. Examples include cash flow management, inventory management, accounts receivable, and accounts payable.

Working capital represents the difference between a company’s assets and liabilities. Current assets, such as cash, accounts receivable, and inventory, can be converted to cash within a year. Current liabilities are debts that mature within a year, such as accounts payable and short-term debt.

Working capital management aims to maintain a healthy balance of current assets and liabilities. A corporation with a lot of working capital may need to be more efficient with its resources. At the same time, a corporation with insufficient working capital may experience financial difficulties.

Effective working capital management can help a company better meet its short-term goals, budget and obligations. A company’s size, structure and overall business strategy can affect its working capital. Other factors include:

• Access to banking services
• Type of industry
• Level of interest rates
• Products or services sold
• Competitors
• Economic conditions

Working capital management is essential for several reasons. First, it can help a company improve its cash flow. By managing its current assets and liabilities effectively, a company can reduce the time it takes to convert assets into cash. This can help the company avoid cash flow problems, such as borrowing money to meet its obligations.

Second, working capital management can help a company improve its profitability. A company can improve its profits by reducing the amount of money it spends on inventory and accounts receivable. Additionally, by negotiating better terms with its suppliers, a company can reduce its costs.

Third, working capital management can help a company reduce its risk. By having enough operating capital, a company can weather unexpected financial challenges, such as a downturn in sales or an increase in costs. This can help the company avoid bankruptcy or other financial difficulties.

Why is Working Capital Management Important?

Working capital management is important because it’s a strategy for ensuring a company has enough money to cover its routine expenses, debts, unexpected costs, and basic materials. It also helps a business minimize the money it spends and maximize its return on investments. Managing its working capital allows a company to improve its earnings and profits. To manage working capital, a company may use key performance ratios that track its current capital, inventory, and cash flow.

This helps identify areas that the company should address to maintain profitability. Effective working capital management is a way for companies to avoid financial problems, increase profitability, improve business value, and maintain an advantage over competitors.

Analysis ratios for working capital management

The current ratio, collection ratio and inventory turnover ratio are the three common analysis tools for managing working capital. Here’s an explanation of each ratio to help you understand them better:

• Current ratio

The current ratio is an indicator of a company’s financial health and its ability to meet short-term financial obligations. A company can calculate the current ratio by dividing its current assets by its current liabilities. Typically, a current ratio below 1.0 means that a company’s liquid assets might not cover its upcoming debts, making it difficult to meet those obligations.

A current ratio between 1.2 and 2.0 is more desirable, while a ratio greater than 2.0 could suggest that the business isn’t managing its working capital efficiently.For example, if the value of an organization’s current assets is $10,000 and its current liabilities is $6,000, then the calculation for its current ratio is $10,000 / $6,000 = 1.667. This is within the optimal range for the current ratio, so the organization chooses to maintain that value.

• Collection ratio

The collection ratio shows how effective a company is at collecting payment after a credit transaction. It may also show how efficiently the company is managing its accounts receivables.A company can calculate its collection ratio by multiplying the number of days in an accounting period and the average amount of outstanding accounts receivable, then dividing that number by the total amount of net credit sales during the accounting period.

Read Also: Key Strategies for Optimizing Working Capital in Your Business

The collection ratio provides the average number of days it can take for a company to receive payment after a credit sales transaction. If a company’s collection ratio is lower, its cash flow is typically more efficient. A company may also refer to its collection ratio as that day’s sales outstanding.

• Inventory turnover ratio

The inventory turnover ratio reveals how quickly a company’s inventory is being used and replaced. To operate at maximum efficiency, it’s vital for companies to maintain a healthy balance of having sufficient amounts of their inventory without exceeding demand. The inventory turnover ratio can help a company avoid having capital stuck in inventory that it isn’t selling, which may cause cash flow problems.

A company can calculate its inventory turnover ratio by dividing its cost of goods by its average balance sheet inventory. Low ratios might show that a business’s inventory levels are excessive. A high ratio may mean that inventory levels are inadequate.

How can Companies Effectively Manage Working Capital?

Working capital is the amount of cash and other current assets that remain after accounting for current liabilities. In other words, it calculates the difference between what you own (cash, treasury bills, stocks, bonds, and inventories) and what you owe (salary expenses, taxes, sections of long-term debt, and other obligations) over the following 12 months.

Working capital may also be referred to as net working capital, which are synonymous terms.

These five techniques for working capital management will help you improve how cash flows in and out of your business, control costs, and collect your income faster. ‍

Let’s take a look.

1. Pay Suppliers on Time

At first, paying bills on time might seem like a backward way of managing working capital since the money is leaving your accounts. But this strategy is all about improving your vendor management and creating better relationships with suppliers.‍

When you consistently pay your bills on time, you help your vendors stay on top of their cash flow. As a result, you get a reputation as a good, reliable client, which enables you to create better supplier relationships. ‍

Positive vendor relationships can help you negotiate better prices and ordering terms, such as discounts for buying in bulk.‍

One of the metrics to watch is your days payable outstanding (DPO), which is the number of days it takes you to pay your bills. You’re paying early if your DPO is shorter than your supplier’s payment terms.‍

One effective way to pay bills faster is to use electronic payment methods, like direct deposit or online credit card processing. This way, your vendors receive the money right away instead of waiting for you to mail a check.

2. Monitor and Control Costs

As a business owner, you’re no stranger to the idea that “it takes money to make money.” While that’s true, there’s a difference between smart business investments and unreasonably high costs that can eat into your profits. ‍

The first step in controlling costs is to start monitoring them. You can start by creating a separate bank account for your business and investing in accounting software. ‍

A business bank account makes separating personal expenses from operating costs easier. This way, you can monitor how money flows in and out of your business over time and understand your normal expense levels. ‍

You can also invest in accounting software that helps you categorize expenses. This way, if you need to cut costs, you can start by looking at your high-spend categories.

3. Collect Customer Payments Faster

One of the best ways to increase your cash is by collecting invoice payments faster.‍

The first step to getting paid faster is sending out invoices on time. After all, if your customer doesn’t receive their bill, they don’t know how much to pay you. Invoice automation software can be helpful here because it lets you create invoices ahead of time and schedule them to send later.‍

You can also collect your money faster by accepting electronic payments, which are faster than checks in the mail. Electronic payments can also be faster than accepting credit or debit card information by phone because you’re not waiting for your customer to find enough free time to call and make the payment.‍

Finally, you may consider options that encourage your customers to pay faster, such as choosing shorter repayment periods or offering discounts for early payment.

4. Improve Inventory Management

Inventory is an asset you can convert to cash by selling it, but before that happens, you have to purchase and store it. ‍If you have too much inventory on hand, your storage costs may get expensive. You may also have to reduce prices to move old inventory, which means less money coming into your business. ‍

But, if your procurement process is off and you don’t have enough stock to fill orders, you miss out on that income, and you may have customers that don’t come back. ‍

Here are some inventory management tactics you can use to improve your working capital:‍

• Check inventory levels regularly: This way, you know when you have too much or too little of an item, and you can adjust your purchases accordingly.
• Measure days inventory outstanding (DIO): Days inventory outstanding measures how many days an item sits in your inventory before it’s sold and tells you about your inventory turnover rate—or how much inventory you sell in a given time. Ideally, you want a shorter DIO because it means you’re selling and converting to cash faster.
• Improve the inventory turnover rates: Once you start measuring the DIO of your items, you’ll see which products move fast and slow. Look at your slow-moving items and brainstorm how you can improve their turnover. For example, you may want to reduce the price or place the item in a more noticeable area of your physical or online store.

Consider using the just-in-time (JIT) inventory system, which means that you order items right before you’ll need them to meet demand (instead of stockpiling inventory). This method helps you keep storage costs low and avoid the need to discount old inventory.

5. Make Smart Financing Decisions

If your inventory and accounts receivable aren’t enough to cover short-term expenses, it’s time to consider outside financing. ‍Short-term loans, sometimes called working capital loans, can help you pay your bills without committing to lengthy repayment plans. ‍

Just make sure to compare the credit terms and interest rates of different providers to choose an option with lower total costs. It may be better to open a new line of credit to continue paying your vendors on time and earn the long-term benefits of having positive supplier relationships. ‍

Now that you know how to manage your working capital, let’s go over how you calculate it.

You can use the following formula to calculate your working capital.‍

Working Capital = Current Assets – Current Liabilities‍

If you’ve ever looked at a balance sheet, you’ll have seen these terms before. But what exactly do they mean?‍

In accounting, the term “current” means that you’ll use up or pay for that asset or liability within one year. Here are some examples of what to include in each category.

Current Assets

• Cash
• Supplies
• Inventory
• Prepaid expenses
• Accounts receivable
• Cash equivalents (treasury bills, treasury notes, certificates of deposit, etc.)
• Marketable securities (stocks and bonds)

Current Liabilities

• Payroll payable
• Accounts payable
• Accrued expenses
• Dividends payable
• Income tax payable
• Portions of long-term debts that are due in the next 12 months

‍Tools like Hourly payroll software can help you keep track of liabilities like payroll payable. But, as you can see, several factors affect working capital. The rest of this article will cover strategies to manage elements like your inventory and accounts payable. ‍

Before we go there, though, let’s look at an example of how to calculate working capital.

Working Capital Example

Let’s say that you do the calculations and have the following assets and liabilities.

Current Assets

• Cash: $100,000
• Inventory: $350,000
• Accounts receivable: $50,000
• Total: $500,000

Current Liabilities

• Payroll payable: $20,000
• Accounts payable: $300,000
• Current debt payments: $50,000
• Accrued expenses: $50,000
• Total: $420,000

‍That means your working capital is $500K – $420K, which gives you $80K.‍

Ideally, you want to have a positive working capital because that means you have enough assets on hand to pay for your upcoming costs. If you have a negative working capital, you don’t have enough current assets to cover your financial obligations for the next 12 months.‍

As a small business owner, it’s up to you to monitor the financial health of your business and ensure you have sufficient cash to pay for your expenses.

What are the Factors Affecting Working Capital Requirement?

Determining the factors affecting the working capital requirement of a business is important to make informed decisions.

1. Business size:

One of the most important factors affecting working capital requirements is the size of a business and the scale of its operations. A company that has multiple manufacturing units and operates on a large scale will have a large working capital requirement. However, they will also have better economic performance because of better bargaining power when compared to smaller business units.

2. Operating cycle length

The operating cycle length, also known as the cash conversion cycle, is a financial metric that measures the time it takes for a company to convert its investments in inventory and other resources into cash inflows. It provides insights into the efficiency of a company’s working capital management and operational processes. The operating cycle is typically divided into three main components:

a. Days inventory outstanding (DIO): Represents the average number of days it takes for a company to sell its inventory. It is calculated as:

DIO = Average Inventory / Cost of Goods Sold (COGS ) per day

b. Days sales outstanding (DSO): Reflects the average number of days it takes for a company to collect payment from its customers. It is calculated as:

DSO = Accounts receivable / Net Sales Per Day 

c. Days payable outstanding (DPO): Represents the average number of days a company takes to pay its suppliers. It is calculated as:

DPO = Accounts Payable / Cost of Goods Sold (COGS) per day

The operating cycle length is then calculated as the sum of DIO, DSO, and DPO:

Operating Cycle Length = DIO + DSO + DPO

Interpretation:

• A shorter operating cycle indicates that a company is efficiently converting its investments into cash, which is generally favorable.
• A longer operating cycle may suggest inefficiencies in inventory management, receivables collection, or payables management.

Key points:

• Efficient working capital management aims to minimize the operating cycle length, ensuring that the company’s resources are utilized effectively to generate cash flow.
• Monitoring and analyzing the components of the operating cycle help identify areas for improvement in inventory turnover, receivables collection, and payables management.

3. Seasonality

Many season-specific businesses don’t see much sales throughout the year. Instead, they witness a surge in sales during a particular season only. For example, businesses selling woolen garments or umbrellas/raincoats experience a surge in demand during winters and monsoons respectively.

The rise in demand lasts for a few weeks or maximum for a few months. The business invariably requires more working capital to meet the increased demand during the period which illustrates why seasonality is one of the crucial factors affecting working capital requirement.

4. Scale of operations

Larger companies typically have more extensive operations, including higher sales volumes and larger production capacities. This can result in higher levels of inventory and receivables, influencing a larger working capital requirement. Smaller businesses may have limited production capacity and lower sales volumes, leading to comparatively lower levels of inventory and receivables. Their working capital needs may be more manageable in scale.

5. Business sales

The volume of sales significantly influences the working capital needs of a business. When aiming to boost sales, an entity must uphold substantial levels of current assets, including inventory and cash. This strategic approach ensures the capacity to meet demand and sustain daily operations.

6. Technology and production cycle

The choice of technology in the production process is one of the pivotal factors affecting working capital requirements. In scenarios where a company adopts a labor-intensive production approach, there’s a heightened need for working capital to ensure a consistent cash flow for compensating laborers. Conversely, if the production process relies on machine-intensive techniques, the demand for working capital is notably reduced.

Additionally, the duration of the production cycle plays a crucial role. A business engaged in a prolonged production cycle necessitates more working capital due to the extended time required to transform raw materials into finished goods. Conversely, a shorter production cycle correlates with reduced working capital needs, as fewer funds are essential for inventory maintenance and raw material procurement.

7. Inventory management

The inventory management policy adopted by a company holds significant sway over its working capital needs. Even for smaller businesses, a substantial working capital requirement becomes imperative when dealing with extensive inventories, irrespective of the turnover pace.

To illustrate the importance of inventory management, consider this scenario: Imagine a business owner opting to accumulate raw materials well in advance of production. In such a case, the working capital requirement surges significantly as resources remain tied up until the entire production process concludes.

Contrastingly, envision a company embracing the JIT (Just In Time) inventory management policy, where raw materials are sourced precisely when the need arises. In this scenario, the working capital requirement diminishes substantially.