Effective working capital management can make all the difference between success and failure in the business world. But how can businesses manage their working capital effectively?
In this article, we’ll explore the basics of working capital management. We’ll also dive into specific techniques that you can use to better manage capital and optimize liquidity.
What is the importance of working capital?
Working capital is a crucial financial metric that measures your company’s ability to meet its short-term financial obligations. It’s the difference between your current assets, such as cash, accounts receivable, and inventory, and your current liabilities, such as accounts payable, short-term loans, and other obligations due within a year.
Working capital is critical for the survival and growth of a business regardless of its size or industry. A company with a strong working capital management plan is better positioned to withstand unexpected financial challenges, such as economic changes, cash flow disruptions, and unexpected expenses. Effective working capital management can also help a company improve its profitability by reducing the need for costly short-term financing options.
Working capital ratios to track
There are several important working capital ratios that you can use to track your financial health and manage your cash flow effectively. These ratios provide insights into your liquidity, efficiency, and overall financial performance and can help identify potential areas for improvement.
The current ratio measures your ability to pay your short-term debts using current assets. It is calculated by dividing current assets by current liabilities. A good current ratio varies depending on the industry and the company’s circumstances. However, as a general rule, a current ratio of 2:1 or higher is considered good.
A low current ratio indicates that your business may not have sufficient liquidity to cover your short-term debts and operational expenses. It may also signal to investors that your company is not well-managed or is experiencing financial stress.
On the other hand, an excessively high current ratio suggests that your company has excess funds tied up in current assets, which could be better utilized elsewhere. It can also mean your company is not efficiently managing its inventory.
Quick Ratio (aka Acid-Test Ratio)
The quick ratio is similar to the current ratio, but it measures a company’s ability to pay off its current liabilities with its most liquid assets, such as cash, marketable securities, and accounts receivable. It is calculated by dividing quick assets by current liabilities. A higher quick ratio indicates that a company has sufficient cash and other liquid assets to cover its short-term obligations.
Inventory Turnover Ratio
The inventory turnover ratio shows how effectively your business manages its inventory levels. It is calculated by dividing the cost of goods sold by the average balance sheet inventory. This ratio indicates how quickly you’re using and replacing your inventory.
A low ratio may suggest that your company is holding onto excessive inventory levels, which can lead to increased costs and obsolescence risk. Conversely, a high inventory ratio could indicate inadequate inventory levels, potentially leading to missed sales opportunities.
Days Sales Outstanding Ratio
The days sales outstanding ratio measures the efficiency of your company’s accounts receivable management. It reveals the average time you take to collect payment after a sale transaction. The lower the ratio, the better your company is performing.
The ratio is calculated by dividing accounts receivable by average daily sales. The result shows how quickly your company turns its outstanding receivables into cash. A low ratio suggests that you are collecting payments more efficiently, which can positively impact your cash flow, profitability, and overall financial health.
Days Payable Outstanding Ratio
The days payable outstanding ratio measures how quickly a company pays its suppliers. It is calculated by dividing accounts payable by average daily purchases. A high DPO indicates that a company manages its cash flow well and has a strong bargaining position with its suppliers.
Managing Working Capital
Measuring working capital is one thing, while managing working capital is another. The following are strategies to help improve your working capital metrics.
Analyze current financial statements and create projections
Current financial statements are required to calculate your working capital ratios accurately. While your financial statements and working capital metrics provide current and historical insight, projections will help you analyze and navigate the future. Create and maintain income statement, cash flow, and balance sheet projections. All too often, business owners focus on income projections when changes in the balance sheet can greatly affect cash flow. For example, an investment in machinery or equipment or non-renewal of a loan can drain cash normally available for operations.
Perform a scenario analysis
Stress test your projections across multiple scenarios and consider how your company might navigate through them, especially in today’s volatile, uncertain, complex, and ambiguous (VUCA) business environment. This is referred to as scenario analysis, and it can help you develop contingency plans to manage your working capital better and avoid cash flow shortfalls.
To perform an analysis, consider various scenarios, both positive and negative. For example, a positive scenario could be launching a successful new product or service that increases sales and revenue. In contrast, a negative scenario could be a sudden economic downturn or change in consumer behavior that reduces demand for your products or services.
Too much inventory can tie up working capital, while too little inventory can lead to stockouts and lost sales. Implement inventory management systems to optimize inventory levels, reduce carrying costs, and improve cash flow.
Monitor your accounts receivable aging report and follow up with customers who have overdue payments. Implement efficient invoicing and payment processes, such as offering discounts for early payment or implementing an automated billing system. Finally, review your process for extending credit to customers; a high DOS (Days Sales Outstanding) ratio may be due to your customer’s ability to pay their bills.
Manage accounts payable
Negotiate favorable payment terms with suppliers to maximize payment flexibility and reduce the risk of late payment penalties. For instance, you might negotiate discounts or longer payment periods, potentially shifting 30-day payment terms to 60 or 90-day terms. Take advantage of early payment discounts and consider using electronic payment systems to streamline payment processing.
Right-size your expenses
One way to improve working capital is to increase profitability. Reassess all expenses to identify those that can be reduced or cut altogether.
Review available credit
Banks are more willing to extend credit when you don’t need it. Therefore, plan ahead and secure a line of credit or other available credit before needing it.
Seek professional advice
Effectively managing working capital can be intricate and demanding. This article is meant to provide an overview of working capital management and is not a substitute for speaking with one of our expert advisors. Consider seeking advice from one of our advisors, who can help you identify opportunities for working capital improvement and provide guidance on best practices. Please contact our office to discuss your unique situation.