The Importance of Working Capital Management

Proper working capital management will help keep your business afloat, avoid cash flow management problems, and see where you may need to borrow money. In conclusion, smart working capital management is important in both meeting short-term financial obligations and strategizing for long-term growth, especially when dealing with potential financial distress. By carefully monitoring cash inflows, you can ensure you’re not only solvent today, but also in a good position for future expansion and investment opportunities.

  1. Say a company has accumulated $1 million in cash due to its previous years’ retained earnings.
  2. In our experience, this includes nurturing awareness and conviction, reinforcing mind-sets and behaviors with formal mechanisms, and deploying the right talent and skills.
  3. For example, unnecessarily spending all of the cash on hand in the short term does not bode well for long-term goals and success.
  4. A good way to judge a company’s cash flow prospects is to look at its working capital management (WCM).

Once you have calculated all of these components, you can easily figure out your working capital. For starters, understanding your working capital also means you understand the financial state of your business. Additionally, working capital is also a large determinant of whether your business can grow, or if an injection of funding will be required to take the next step as a company.

It’s a step-up opportunity for CFOs to get deep into the business and work collaboratively with their colleagues on what is a challenging but also high-potential topic. 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 keeping a constant pulse on your working capital. One solution to this problem is invoice factoring, which use invoices 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 as a quick source of cash because not every business can meet the credit terms necessary to qualify for traditional business financing. Ultimately, the importance of working capital is that it helps ensure your business can keep operating, and that its resources are being used wisely.

In a given sector where, for instance, it is normal for a company to completely sell out and restock six times a year, a company that achieves a turnover ratio of four is an underperformer. To calculate the ratio, you simply divide current assets by current liabilities rather than subtracting one from the other. The company can avoid taking on debt when unnecessary or expensive, and the company can strive to get the best credit terms available. The company can be mindful of spending both externally to vendors and internally with what staff they have on hand. All organizations know the importance of managing cash and working capital; without them, organizations simply cannot exist. Yet, when targeting growth, too many organizations focus on trying to increase sales or reduce supplier costs, while ignoring
the potential benefits of efficient working capital management.

Some approaches may subtract cash from current assets and financial debt from current liabilities. Dell’s exceptional working capital management certainly exceeded those of the top executives who did not worry enough about the nitty-gritty of WCM. Some CEOs frequently see borrowing and raising equity as the only way to boost cash flow. Other times, when faced with a cash crunch, instead of setting straight inventory turnover levels and reducing DSO, these management teams pursue rampant cost cutting and restructuring that may later aggravate problems. The quicker the company sells the spaghetti sauce, the sooner the company can go out and buy new ingredients, which will be made into more sauce sold at a profit.

How to Calculate Working Capital

The company has more than enough resources to cover its short-term debt, and there is residual cash should all current assets be liquidated to pay this debt. Three ratios that are important in working capital management are the working capital ratio (or current ratio), the collection ratio, and the inventory turnover ratio. This is especially important in the short-term as they wait for credit sales to be completed. This involves managing the company’s credit policies, monitoring customer payments, and improving collection practices.

One natural-resources company, for example, recently reduced its working capital by more than 40 percent in the space of a year. Proper management of working capital helps the business pay its outstanding debts on time, creating goodwill and adding value in the market. Create an accounts receivable aging schedule each month that lists the dollar amounts you’re owed based on the invoice date. For example, automating payment processing will keep invoices top of mind for customers and increase the likelihood that they will pay promptly. Ensuring that the company possesses appropriate resources for its daily activities means protecting the company’s existence and ensuring it can keep operating as a going concern. Scarce availability of cash, uncontrolled commercial credit policies, or limited access to short-term financing can lead to the need for restructuring, asset sales, and even liquidation of the company.

Working Capital Management

In practice, it deals with the cash conversion cycle – or, how long it takes to turn inventory into sales, receive payment, and pay vendors. Working capital management refers to the process of managing your current assets and liabilities in order to ensure efficient and effective use of your working capital. The goal of effective management of working capital is to strike a balance between maintaining adequate liquidity to meet short-term obligations and maximizing the profitability and efficiency of your business.

Why Working Capital Management is Important

Working capital management is a business strategy designed to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to their most effective use. It is not
the only measure, and it is certainly not a guarantee of a company’s
ability to pay. A company may have positive WC, but not enough cash to
pay an expense tomorrow. Similarly, a company may have negative WC, but
may be able to adjust some of their debt into long-term debt in order to
reduce their current liabilities. Finally, working-capital performance rarely improves uniformly across every business unit and region, or across inventory, receivables, and payables. Performance dashboards can allow managers to review a significant degree of detail, identify pockets of success, and quickly address problem areas.

WC can also be
described as the amount of money that a small business or start-up needs
to stay in operation. Start-ups need to pay attention to their WC
because it is the amount of money they need to keep the business running
until they break-even (start earning a net profit). Maintaining a good reputation in the market due to timely payments and fulfilling commitments helps the business easily obtain contracts and generate more business.

Understanding working capital as a small business owner can help you grow your business or take advantage of bigger opportunities. You can use this and other financial ratios to better understand your business’s short-term financial health. 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 ensure your company stays healthy and sets you up for growth.

There are dozens of factors that affect an organization’s working capital requirement. Not all factors relate to all businesses, and the capital levels you need at any given time depends on your specific business model. How business owners handle these five vital components determines how well (or how poorly) they manage their working capital. Analyzing a company’s working capital can provide excellent insight into how well a company handles its cash, and whether it is likely to have any on hand to fund growth and contribute to shareholder value.

Business Bank Accounts

Although many factors may affect the size of your working capital line of credit, a rule of thumb is that it shouldn’t exceed 10% of your company’s revenues. Your net working capital tells you how much money you have readily available to meet current expenses. Yet, when considering a potential transaction, working capital is often overlooked. Get instant access to revolving credit with unlimited terms, and the best rates for your business. That can produce hundreds of ideas for initiatives that build momentum with a steady drumbeat of success stories. A business can invest extra working capital to create short-term profits rather than keeping a heavy amount of funds as working capital, which may not be necessary.

Additionally, it also helps to ensure your business is set up for future growth opportunities and expansion. One crucial aspect of managing working capital is making the distinction between certain assets. While calculating working capital involves lumping all current assets together, it is worth considering how different assets’ liquidity varies. Now we understand how to use the formula for working capital, it’s important to establish why working capital is important. Simply put, working capital is what keeps a business afloat, as it allows for the purchase of goods and services, paying staff and paying off debts.

The current ratio is a key indicator of a company’s financial health as it demonstrates its ability to meet its short-term financial obligations. Stories like these happen every day by the hundreds, or even thousands, in large companies, at all levels and across business units and geographies. Many variables are in play, and responsibility is spread unevenly importance of working capital across finance, operations, supply chain, marketing and sales, and procurement. Working capital affects several aspects of your business like paying your employees, keeping operations running, and planning for long-term goals. Furthermore, calculating and understanding NWC is important because it measures how efficiently your company is operating.

The company’s policies and manager’s discretion can determine whether different terms are necessary, such as cash before delivery, cash on delivery, bill-to-bill, or periodic billing. A company should grant its customers the proper flexibility or level of commercial credit while making sure that the right amounts of cash flow in via operations. Proper liquidity management is manifested at an appropriate level of cash and/or in the ability of an organization to quickly and efficiently generate cash resources to finance its business needs. Properly managing liquidity ensures that the company possesses enough cash resources for its ordinary business needs and unexpected needs of a reasonable amount. It’s also important because it affects a company’s creditworthiness, which can contribute to determining a business’s success or failure. Working capital management traditionally consists of several key components that can determine your business’ financial health.

Understanding Working Capital Management

In calculating the net cash flows for use in the income approach, the analyst will make an adjustment for the increase in working capital that the company will need in order to fund its expected growth. Working capital financing helps you keep your business running when you need to cover a cash flow gap. Unfortunately for many of those businesses, securing financing is an arduous process.