Put as simply as possible, working capital is the difference between a company’s assets and liabilities. If a company has $300 in cash, $200 in unpaid bills and $500 in inventory, it has $1000 in assets; the same company might have $100 in its accounts payable and $200 in business debts, meaning it has $300 in liabilities. Thus, this imaginary company has a working capital of $700.
Working capital is a useful tool for determining the health of an organization. Too little working capital, and a business might not have the resources it needs to function, but too much working capital and the business might not be properly investing in itself to result in growth. Managing working capital tends to be a significant stress for new business leaders, who often struggle to find the perfect balance in saving and spending to ensure a healthy and successful company.
In truth, effective working capital management requires the right tools and plenty of experience. However, young and green business leaders can improve their management of working capital using the following quick tips:
Make Payments on Time
Prior to the COVID pandemic, a popular strategy for working capital management was working with vendors to extend the number of days in which they could maintain outstanding payables. However, these days, vendors are not tolerant of late payments, and a business leader cannot afford to alienate a vendor and disrupt their supply chain. Developing better relationships with vendors by making payments on time and in full will give an organization a stronger position with which to negotiate better deals and discounts.
Monitor Procurement and Inventory
To navigate the weak supply chain of the post-pandemic world, many large organizations have opted to increase their buffer stock to thwart costly disruptions in supply chain deliveries. However, this is a perilous strategy. It is possible to tie up too much working capital in inventory; storage costs can be high, and if demand plummets, the business will struggle to liquidate its stock and obtain the capital it needs to pivot toward success. Then again, the dangers of insufficient inventory have been well-documented through the end of the pandemic, as companies have suffered lost sales and damage to customer relationships. Thus, business leaders need to be careful with how they manage procurement and inventory in relation to their availability of working capital.
It is not uncommon for business leaders to count sales incomes in their available working capital, but the truth is that until that money is received, it is not available for use. Thus, businesses should work to improve their receivables process, which involves creating an effective collections system that does not allow for any delays in processing payments. The shorter the receivables period, the sooner business leaders have access to the money locked up in their sales invoices, and the more working capital will be at their disposal for growing a stronger and more successful organization.
Assess and Reassess Debts
Some businesses maintain contracts and credit terms with debtors, which is a dangerous practice that can be lucrative when properly managed. Business leaders need to be careful to assess and reassess their credit terms regularly to ensure that debtors’ payment windows are adequately contributing to a positive company cash flow. Businesses should be careful not to extend credit to unreliable debtors, who will only pull down working capital and make it more difficult to conduct effective business.
Measure Working Capital Properly
It is exceedingly difficult to manage working capital if a business leader has no sense of how much working capital is available at any time. Thus, business leaders need to identify key metrics for measuring working capital, and they need to take measurements as often as quarterly or perhaps monthly to understand how their working capital ebbs and flows. Typical key performance indicators of working capital include debt-to-equity ratios, accounts receivables turnover, days payable outstanding and days inventory outstanding. Once an organization has a reliable method of measuring working capital, leaders can develop targets for more efficient working capital operations.
A business does not want too much working capital, but too little working capital is likewise a problem. With careful and proper management, a business leader can achieve the perfect working capital balance that leads to success.