Management of working capital is a critical area that many businesses neglect.
But because this area is often neglected, there’s plenty of potential for optimization. Improving working capital management ensures a business operates efficiently by getting the maximum use of its assets and liabilities.
Reduced working capital can free up invested funds to be reinvested for further growth or even shifted out of business, improving your return on capital employed.
This guide aims to give more information on working capital and reliable strategies for managing it.
What is Working Capital?
Working capital refers to the funds needed to run a business. It’s the difference between current assets and current liabilities and a measure of how efficiently a business can operate.
Current assets are the assets a business hopes to sell or use over the next year for standard operations and include:
- Cash and its equivalents
- Accounts receivable
- Prepaid expenses
- Marketable securities
They’re an essential aspect of the business since they ensure it can meet its obligations to customers, suppliers, and employees while ensuring smooth day-to-day operations.
On the other hand, current liabilities are a business’s short-term financial obligations and include:
- Accounts payable
- Taxes payable
- Any long-term debt due within the year
Why is Working Capital Mismanagement Important?
A business needs to remain solvent and have enough cash to pay bills and salaries. Managing working capital ensures liquidity while maximizing returns.
Consequently, mismanagement negatively affects a company’s financial health and liquidity. Low liquidity means the business does not have enough money for regular expenses, leading to debts and bankruptcy. In short, too much money is unnecessarily tied up in the business.
Tips for Better Management of Working Capital
Improving profitability is a core factor in improving working capital. Higher margins mean keeping more of your sales for yourself and the business, which increases cash flow.
Aside from improving profitability, a few significant levers can help you free up invested capital.
Keep a Watchful Eye on Your Inventory
Proper management of inventories is powerful leverage for reducing the level of funds tied up in the business. Inventories entail both finished products and raw materials.
Since buying inventory is an investment, you can’t have too much or too little. Of course, you do need to have enough materials to meet your customers’ needs, but you don’t want so much that products go unsold for months or years. Finding a good balance is essential.
You can start by tracking metrics like inventory turnover, return on investment (ROI), and
average days to sell.
Inventory turnover refers to the number of times you sell your inventory within a year and is closely related to the average days to sell.
Average days to sell refers to the time you take to convert inventory to sales. An ‘average days to sell’ of 30 days means turning over your inventory 12x each year. Therefore, the fewer average days, the better for your business.
A low turnover indicates sales didn’t go as expected, while a high turnover means you may have underestimated demand. Monitor inventory regularly to ensure that your business is operating smoothly and that you control your stock efficiently.
Improve Your Accounts Receivable
You can improve accounts receivable (AR) by shortening the time to collect what is due to you. There are several ways to accomplish lower AR. But at the core of a low AR is a sound collection system.
Some simple methods of reducing AR involve:
- Simplifying customer payment options
- Implementing a clear credit and overdue policy
- Promptly sending invoices
- Following up on invoices
For companies with large invoices, try implementing an automatic payment reminder shortly before the due date.
Conduct Frequent Cash Flow Analysis
Cash flow is vital in managing working capital, and a business needs to have consistent inflows to survive. It’s crucial to ensure your current assets are in a form that is easily convertible to cash and that you take the time to frequently monitor your cash flow.
If cash flow is tight, try:
- Improving accounts receivable – regularly follow up with customers that don’t pay on time. If you need to, reduce their credit terms to reduce the squeeze on your end.
- Reworking vendor contracts – asking vendors to extend payment terms can give you a little extra buffer each month., and
- Revisiting your budget – businesses often collect tools and subscriptions that were once helpful but are no longer in use. Frequently checking your ledgers can help you make sure all expenses are justifiable.
Let an Experienced Accounting Partner Lead the Way
Intelligent working capital management is essential for any successful business. You need adequate capital to pay your suppliers and employees on time and settle taxes and other business-related expenses. However, money tied up in the business’s operations are funds that can’t be used elsewhere.
If your business’s working capital needs feel challenging, maybe an outside set of eyes could help you improve. Founder’s CPA is an accounting partner that offers solutions for improving and managing working capital. Contact our professional team today for a free consultation.