Managing working capital is essential when operating a business, but there may be many small business owners who hear the term working capital but don’t fully understand what working capital is and why it is important.
What is working capital?
Working capital represents the difference between a business’s current assets and current liabilities.
Current assets include things like cash, accounts receivable, and inventory, while current liabilities include obligations like accounts payable or short-term debts.
Working capital serves as a measure of a company’s liquidity and operational efficiency. Positive working capital indicates that a company can cover its short-term obligations, while negative working capital might signal financial struggles. It essentially represents the funds available to manage the daily operations of a business, like paying suppliers and salaries, or purchasing inventory.
Key reasons why working capital is important
Working capital is vital for businesses because it directly impacts their ability to operate smoothly and handle day-to-day expenses. The following are some key reasons why working capital is important:
- Cash flow management: Working capital ensures that a business can cover its short-term liabilities, such as rent, salaries, utilities, and supplier payments. Without sufficient working capital, businesses may struggle to meet these obligations.
- Operational stability: Working capital acts as a financial buffer, allowing the business to manage unexpected costs or delays in revenue collection. This stability is especially important for small businesses that can often face variable trading conditions.
- Growth and investment: Adequate working capital provides businesses with the flexibility to invest in growth opportunities, such as purchasing more inventory, expanding into new markets, or purchasing equipment to help grow or increase the efficiency of the business.
- Creditworthiness: Healthy working capital demonstrates financial health, making it easier for businesses to secure loans or negotiate better terms.
- Customer satisfaction: A good working capital position ensures timely delivery of goods or services to customers, which helps maintain trust and loyalty.
Improving working capital
Businesses often operate on tight margins, so effective working capital management can mean the difference between a business thriving or a business facing financial difficulties. The following are some strategies to improve working capital:
1. Cash flow analysis
Forecasting cash inflows and outflows can ensure enough liquidity for day-to-day operations. Having good systems in place to monitor and forecast cash flow, then monitoring and acting on this as needed will greatly assist in ensuring a business has adequate working capital.
2. Accounts receivable management
Managing accounts receivable to ensure timely payment will help improve working capital. Strategies to improve accounts receivable management include:
- Establish clear payment terms
Define payment policies and terms before extending credit to clients. For instance, set payment deadlines, late penalties, and available discounts for early payment. Communicating these terms clearly can prevent misunderstandings. - Monitor and follow up on invoices
Implement a system for tracking outstanding invoices and send timely reminders to customers about upcoming or overdue payments. Automated invoicing software can help streamline this process and minimise delays in payments. - Credit risk assessment
It’s important to evaluate the creditworthiness of clients before entering working agreements. By conducting background checks or reviewing payment history, you can minimise the risks associated with late payments or defaults. - Offer multiple payment options
Make it convenient for clients to pay by providing multiple payment methods, such as bank transfers, credit cards, and online payment platforms. Convenience can encourage faster payments.
3. Inventory management: Managing inventory can help ensure you don’t end up holding too much inventory, obsolete inventory, and reduce wastage of inventory, which all can impact cash flow and working capital. Strategies to improve inventory management include:
- Implement inventory tracking systems
Setting up inventory management software to monitor stock levels, locations, and movements in real time. This can help prevent overstocking or understocking. - Regularly conduct stock audits
Performing periodic physical stock counts to identify any discrepancies with system records. - Regularly monitor stock levels and aging
Utilising the systems in place is important, so you can act if your stock levels are to high or low, or to help minimise or reduce carrying old or obsolete stock.
4. Accounts payable optimization: Managing accounts payable can ensure you are making use of favourable payment terms. Strategies to improve accounts payable management include:
- Negotiate payment terms
Work with suppliers to negotiate payment terms such as extended deadlines or obtaining discounts for early payments. - Use a cash flow strategy
Align payment schedules with cash flow cycles to minimise having to make large payments at times when cash flow may be low.
5. Performance metrics: Monitor working capital ratios and other financial indicators to keep track of your business’s financial health.
Next steps
Your Nexia Advisor can help you and your business with monitoring your working capital. Contact our knowledgeable team for assistance with strategies to help improve the financial health of your business.
