The Fundamentals of Working Capital

Working capital: you can’t make your business work without it.

In this article, we’ll cover what working capital is and how you can identify and correct inefficiencies to streamline cash flow and support sustainable growth.

“While there are no hard and fast rules when it comes to the right balance of current assets to current liabilities, many business analysts recommend a ratio between 1.5 and 2.0.”

First, let’s start with a basic definition of working capital, aka net working capital (NWC). It’s the difference between a company’s current assets and its current liabilities, and it represents the resources that can be used to carry out day-to-day business activities.

As a key financial metric, working capital can indicate a company’s operational efficiency and ability to meet short-term obligations. If a company has insufficient or negative working capital, it risks not being able to keep the lights on. Conversely, if a company has excess working capital, it could mean that it’s not investing enough in long-term assets and growth strategies.

While there are no hard and fast rules when it comes to the right balance, many business analysts recommend a ratio between 1.5 and 2.0.

As an example, let’s take a look at this excerpt from Company XYZ’s balance sheet:

 

Cash and cash equivalents           $20,000

Accounts receivable                        $80,000

Inventory                                            $55,000

Investments                                       $25,000

Total Current Assets                       $180,000

 

Accounts payable                             ($50,000)

Notes payable                                   ($15,000)

Accrued wages                                  ($25,000)

Taxes payable                                    ($10,000)

Total Current Liabilities                  ($100,000)

 

In this instance, Company XYZ’s net working capital would be $80,000, with an idea ratio of 1.8.

Now, let’s take a closer look at three main elements of working capital – receivables, payables, and inventory – and how you can manage them for better financial performance:

Receivables

Receivables, or accounts receivable (A/R), are the funds owed to a business by customers for goods or services provided.

Receivables are classified as current assets on a company’s balance sheet and are part of the working capital formula, but the funds they represent can’t be used to cover expenses until it’s collected. If your company has a high volume of sales on credit, even a slight decrease in your average collection period can significantly increase the amount of cash you have on hand.

Strategies for getting paid faster include negotiating shorter terms with customers, providing discounts for early payment, and offering a range of convenient payment methods.

Payables

Payables, or accounts payable (A/P), are the funds that a business owes to suppliers or vendors.

While a business wants to collect its receivables from customers as quickly as possible, delaying payables to vendors as long as possible is often a best practice for an enhanced cash position. Many companies routinely wait until the end of each payment term unless there’s a discount or other incentive to pay early.

For businesses with a shorter payables cycle than receivables cycle, it can be smart to strive for relative parity. Cash management tools like controlled disbursement services can help companies to optimize the timing of vendor payments.

Inventory

Inventory, or stock, refers to the goods and materials that a business uses in production or holds for resale at a profit.

For inventory-based small businesses, it’s essential to implement a system that meets customer demand without tying up too much capital. Your specific industry and prevailing market trends will determine which is best: a “push” system (with a generous supply of finished products on hand), a “pull” system (where inventory is sourced on demand), or a happy medium.

Careful demand analysis can help you find a solution that keeps your inventory low without hurting sales or increasing procurement costs.

Ready for a deeper dive? Here are some more actionable tips for addressing gaps and planning for sustainable growth:

• Communicate
  Optimizing working capital isn’t just the job of one person or department. Ensure that everyone on your team understands the importance of working capital and the factors that drive it. Larger organizations should consider establishing a cross-departmental committee focused on aligning operations and objectives.

• Measure
  Pay attention to key performance indicators that relate directly to working capital, like days payable outstanding (DPO). Here’s that formula: (average accounts payable ÷ cost of goods sold) × number of days in your accounting period. The higher your DPO, the better your cash flow.

• Compare
  In addition to tracking your own business’s performance and setting internal benchmarks, it’s important to see how you measure up against industry peers. Explore public financial data and research studies to identify leaders and best practices for working capital optimization within your particular sector.

• Negotiate
  Positive vendor relationships are crucial to good cash flow management. Paying your invoices on time puts you in a stronger position to negotiate more favorable payment terms down the road. Consolidating vendors can also give you leverage as well as potential bulk and freight discounts.

• Manage
  Inventory management is another piece of the working capital puzzle that can be highly dependent on your industry and market. Many firms have benefited from adopting “just-in-time” strategies, in which inventory is ordered only to meet customer demand, thus minimizing tied-up cash and overstock risks.

• Automate
  Automating your accounts with the latest digital tools can reduce labor costs and errors, and it can also accelerate your cash conversion cycle. Offering electronic payment options to your customers gets you paid faster, while using automated bill pay tools can increase your DPO.

• Enforce
  When it comes to optimizing receivables, it’s smart to facilitate punctual settlement with clear and accurate invoices, convenient merchant options, and discounts or other incentives for early payment. But you may need to implement a carrot-and-stick approach, with automated payment reminders and late fees.

• Save
  Cutting costs wherever possible ensures that your business has the cash it needs to meet essential obligations. Scour recurring charges – many small businesses are paying for unused subscriptions. Also, see whether your municipality offers free energy audits that could help you save on utilities.

• Check
  Before you extend credit to a new client, do your due diligence and assess their creditworthiness. While there’s nothing in business that doesn’t involve some risk, you don’t want to take on clients that have a long track record of paying late or defaulting.

Work With Us

To achieve the right working capital ratio, you need the right financial solutions for your specific circumstances and goals. To explore your options, reach out to an ENB Small Business Relationship Manager.