Working capital management and why is it important?

If you run a business venture, you need to realize the relevance of working capital in ensuring seamless operations. Working capital is the lifeline of any entity, and its appropriate availability sustains its regular business functioning. One can imagine the vitality of working capital through its effect on the profitability of a company. According to expert reports, the EBITDA value rises by almost 20 percent if the business retains working capital efficiency.

Do you want to ensure undeterred access to working capital in your business? Join us to uncover the tricks and tips regarding working capital management.

First, let us understand some basics about working capital and its management.

What is working capital?

Working capital denotes the amount of money that a business has to cater to its day-to-day operational requirements. According to Investopedia, working capital is the money a business firm would have left over if it were to pay its total current liabilities with its current assets.

How to calculate net working capital?

In order to estimate the net working capital for any given financial period of a business, one needs to use the following basic formula.

Working capital = Current Assets – Current Liabilities

Thus, we observe that the net working capital available in your business is dependent on two major factors: your current assets and current liabilities. The state of each of the components of your current assets and current liabilities, such as trade receivables, inventory, cash on hand, trade payables, and short-term loans, impacts your working capital efficiency.

Therefore, it is crucial to address issues related to such constituents that form your business’s current assets and current liabilities. It is when working capital management comes into the picture.

What is working capital management?

In common parlance, working capital management refers to the various tactics a business entity employs to regulate its current assets and current liabilities to attain working capital efficiency. The process of working capital management entails handling matters related to multiple domains such as accounts payable management, inventory management, and receivables management.

What is the importance of working capital management for your business?

One can discern the gravity of working capital management through the fact that insufficient working capital stands amidst the prominent causes of business closure worldwide. Adequate liquidity in your business is fundamental to mitigate your everyday cash needs. Working capital management enables you to fortify your business liquidity and avert financial risks. It allows you to prevent scenarios where your business is left high and dry due to the lack of necessary operating working capital. The medium of working capital management acts as a backing to attain the significant goals for any business entity like growth, profitability, liquidity, or increased return on capital invested.

What are the main approaches for working capital management?

A business team should use a pre-determined approach to undertake working capital management in its organization. It must select the approach as per the individual business’s financial position and operating capital needs. These approaches usually deal with how we regulate the amount of current assets and current liabilities. Generally, business concerns opt for any of the following three approaches for working capital management.

1. Aggressive approach

The aggressive way of working capital management involves keeping the investment in current assets at a minimum level. The current assets are maintained just to cater to the current liabilities. This approach focuses on meeting the working capital requirements from the sources of short-term funding as it discourages keeping idle funds.

2. Moderate approach

This working capital management approach emphasizes paving the middle way between the other two management strategies. Also called the hedging approach, it comprises the process of categorizing the working capital into temporary and fixed categories. Thus, it allows long-term capital for permanent working capital requirements and short-term funding to address the changing temporary working capital necessities. Businesses need to gain a balance between the cost of idle funds and higher liquidity under this approach.

3. Conservative approach

In contradiction to the aggressive approach, the conservative approach for working capital management promotes increased business capital investment in the current assets. A business entity following this approach shall avoid the risk of lesser liquidity by retaining current assets in surplus. However, the finance cost of unused funds is also high if one uses this approach.

Main elements of working capital management

Conventionally, a business must analyze the following components while deciding its working capital management strategies.

Accounts payable

The accounts payable indicate the amount of short-term obligations you need to fulfill in the near future. Delay in the payment to your accounts payable can result in increased interest costs. To manage their accounts payable, many business enterprises look for prolonged payment terms.

Accounts receivable

Accounts receivable refer to the amount your customers are obliged to pay for the product or service offerings your business delivers to them. Your business entity’s accounts receivable showcases your capacity to meet your current liabilities. The accounts receivable also include the payments which your debtors have agreed to pay but remain outstanding.

Inventory

The stock-in-trade or inventory of your business acts as an instrumental component in working capital management. You need to balance the volume of stock at a given time in your organization. An increased inventory affects the liquidity of your business, while a lower stock can affect the capability of your business to timely cater to your client orders.

How to improve the working capital management of your business?

Are you seeking ways to better your working capital efficiency? Let us explore some tried and tested strategies to assist your business in better working capital management.

Optimize expenses

Your business entity must keep a check on its spending to avoid negative cash flows in the business. Often it is arduous to maintain an equilibrium between the money spent for purchases or acquisition of business assets and the duration taken for the receipt of customer payments. If you downsize unnecessary business costs, you can gain more liquidity. However, you must take into consideration the long-term picture before cutting back on your current expenditures.

Prevent piling of business stock

There stands a correlation between your entity’s working capital management and inventory management strategies. Prominent surveys point out that over 69 percent of businesses view inventory management as one of the best ways to better business operations, especially since the pandemic. There are two extremes you need to avoid while regulating your inventory. Do not lower your inventory levels to such a scale that you face obstacles in promptly meeting production and customer demands. Also, you must prevent piling up of business stock as it ties up a considerable chunk of your liquid capital and results in increased stock storage and maintenance costs.

Conduct thorough background checks on prospective customers

As portrayed above, accounts receivable is among the key constituents of working capital management. Thus, entering into business relationships with clients that hold the capacity to buy and make scheduled payments for your products is desirable. Keep customers with low credit scores at bay. Ensure that you undertake adequate background checks on clients before entering into any business agreement.

Lower the amount of debt servicing expenses

Most business ventures, particularly small and mid-sized ventures, need to borrow funds to finance their multiple business requirements. However, with borrowings comes the cost of interest and late fees on delayed repayments. Ultimately, it can drain out a significant portion of your working capital. Thus, take measures to reduce the debt servicing costs in your business.

Use working capital management ratio for better insights

Businesses can utilize the working capital management ratio to establish the status of their financial health. This ratio, also known as the current ratio, is derived by dividing the value of the current assets by that of the current liabilities. A ratio less than 1 or greater than 2 indicates issues with your financial strategies. It is advisable to take corrective measures according to the ratio you derive for your business.

Focus on maintaining cordial vendor relationships

Working capital management is not just restricted to financial strategies but also involves managing supplier relationships. Sustaining good rapport with your vendors must be your priority. Getting into disputes with your suppliers can affect your cash flows negatively.

Ensure prompt payment of outstanding debts

Mismanagement of your loan payments can be a cause of concern as it affects your working capital position. Negative working capital is the last thing a business wants. Thus, adopt ways to timely make debt payments and maintain a decent credit score for your business.

Hire professional support

Many business owners may find it taxing to implement proper working capital management strategies without professional aid. It is best to engage specialists who understand the intricacies of working capital management.

Conclusion

Working capital is the fuel you need to run your business entity’s engine. Hence, it is imperative to improve working capital management in your organization if you are facing liquidity crunches. Working capital management may feel tricky. However, the strategies we highlighted above can give you the right direction towards fruitful results.

To see how quickly the money tied up in stock and receivables turns back into cash, track your cash conversion cycle. And if your finance team keeps payables, receivables, and cash flow in spreadsheets, Sheetgo’s AI finance virtual employee can take on much of that routine work.