Achieving the right working capital is a fine balance. Having too much cash tied up can make it difficult to cover everyday financial obligations and also prohibit growth opportunities. On the other hand, having too much available working capital is often a sign that money isn’t being reinvested into the business efficiently.
Without enough working capital, a business can’t meet its operating costs – whether paying suppliers and salaries, or covering maintenance costs and replenishing stock. But more than this, skilfully managed working capital is also a reflection of successful business management. Indeed, working capital is often used as an indication as to whether a company could be a good investment.
Three aspects regulate the balance of working capital: receivables, inventories and payables.
- Receivables – the amount owed to a business – are designated as assets, and require a seamless collection process to ensure the working capital balance stays healthy.
- Inventory levels also need to be carefully maintained; too much stock leaves a company vulnerable, as cash is tied up in the goods. Conversely, excess cash and too little stock means missing out on valuable sales.
- Payables – the amount a business owes to creditors – is also a key factor in working capital balance as longer repayment terms mean a business can earn interest on cash for longer.
There are a number of ways you can optimise your working capital – but excelling in credit management is critical. By screening your prospective and current customers to assess their payment behaviour and creditworthiness, you can help ensure your working capital is supported by prompt payment.
You can also review your billing and collection process to ensure its efficacy. By reducing your days sales outstanding (DSO), the impact to your business could be huge. If your DSO is too large, not only will you suffer from lower cash flow, you’ll also miss out on the interest of your accumulated outstanding income. Categorising late payers and identifying which areas or customers are causing the biggest problem is a good first step. You can then assess your approach, consider where it’s falling short and, if necessary, involve an external company to improve your processes.
There’s a simple formula you can use to ascertain whether your business’s working capital is optimised: the working capital ratio is calculated as current assets divided by current liabilities.
Assets include any cash held by your business, as well as accounts receivable, marketable securities (financial instruments that can easily be converted into cash, such as stocks and bonds) and your business inventory. Liabilities include your accounts payable, dividends, accrued expenses (including wages, interest and outstanding tax) and the current portion of long-term debt due in the next 12 months.
As the volume of working capital will vary hugely between companies depending on their size, the working capital ratio is an effective tool to standardise this picture. A ratio between 1.2 and 2 is considered good. Anything below 1 is considered negative working capital. A score higher than 2, however, may seem positive in theory, but is typically suggests a company isn’t reinvesting excess cash effectively. Often, this indicates a lack of operational efficiency or a weak financial strategy.
When looking at working capital, it’s best to measure this between similarly sized companies, to get an idea of the industry standard for the size of the enterprise.
If a company’s working capital has increased, this could either be due to a growth in its current assets, a decrease in its liabilities, or perhaps both.
While working capital provides useful insight, the level and timing of a company’s cash flows are arguably more important when assessing its ability to repay liabilities. A company with a high volume of current assets may still have reduced liquidity if assets are disproportionately tied up in inventory.
Achieving a positive working capital balance can safeguard your business and help you capitalise on growth opportunities. But it can also influence your ability to secure additional financing, loans and investments. As this figure changes constantly, it’s important to apply regular attention and dedicated resources to ensure healthy working capital and a financially secure business.