Striking the right working capital balance is crucial to your company’s health
The term ‘working capital’ defines a company’s operating liquidity, i.e. its ability to cover its short-term debts and continue to operate. Good working capital is therefore critical to a company’s health and getting this balance right is a challenging job.
How is working capital measured?
Working capital is calculated through the following equation:
Working Capital = Current Assets divided by Current Liabilities
Current assets include both accounts receivable (completed sales that are awaiting payment) and inventory (company stock that’s available for sale), while current liabilities include accounts payable (money owed by the company).
A healthy working capital balance, where current assets exceed liabilities, means that a company can continue to operate, cover maturing short-term debt (typically, debt payable in the next 12 months) and short-term operational expenses.
However, if current liabilities are larger than current assets then the company has a working capital deficiency. This could lead to it being unable to repay creditors and continue operating – which could result in bankruptcy.
Working capital growth
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.
It’s generally considered that a working capital ratio of between 1.2 and 2.0 is adequate. For example, if a company has assets of £2 million and liabilities of £1 million, then its working capital ratio is 2. Anything below 1 suggests negative working capital, while conversely, anything above 2 can indicate that a company is not reinvesting its surplus assets or has too much inventory.
Working capital can therefore be a strong indicator of a company’s operational efficiency. For example, if a company is not collecting its debt in the allocated timeframe, this may be reflected in its working capital and indicate an underlying issue in the business’s operations.
Working capital management
This is why effective management of working capital is crucial. Not only does it safeguard the company’s ability to operate and repay short-term debt, but it can also influence a company’s ability to secure additional financing, including bank loans and investments.
Working capital is a constantly changing figure and requires key resources to managing it. A number of stakeholders play an important role in maintaining an optimal balance, including credit managers, accounts receivable employees, stock managers, accounts payable employees and purchasing employees.
Key stakeholder responsibilities
The Chief Financial Officer is responsible for promoting optimal working capital, and developing and implementing the financial strategy to support this.
Credit Managers have a significant influence on the available working capital as they are responsible for setting the credit policy and striking the balance between profitable sales and risk management.
Within the credit management department, credit controllers are responsible for ensuring the creditworthiness of potential and current customers, and setting an appropriate credit limit. Credit collectors, meanwhile, monitor invoices and collect debt.
Cash managers play a vital role through handling short-term cash flows and guaranteeing the company’s liquidity. If there is a deficit, cash managers search for inexpensive credit, while in the case of a surplus, the treasurer looks for the best investments to make.
How to address a working capital deficit
If a company is suffering from a working capital deficit that can’t be resolved through internal measures, there are a number of external options that should be analysed carefully to decide whether they suit the company’s needs. These range from bank loans to factoring and reverse factoring (advancing payments either from customers or from the company to its debtors), crowdfunding, leasing and credit unions. Above all, consistent attention and dedicated resources are the best way to safeguard healthy working capital.