Cash flow is critical to any business, but having too much cash tied up can mean lost opportunities and less room for growth. On the other hand, having too much working capital means too much hidden capital tied up in stocks etc. Working capital management should be amongst the top priorities for companies to strike the ideal balance between working capital and cash flow. We provide you with a wiki to explain the importance of working capital, how you can improve it and what are the latest developments surrounding this critical entity.
What is Working Capital?
Working capital is the capital that companies require to meet their everyday financial obligations and commitments to operate successfully i.e. ability to pay suppliers, salaries payable, maintenance costs, replenish stocks etc. In accounting terms, it’s the difference between current assets (such as inventories, accounts receivables and cash) and current liabilities (such as accounts payable and other short term liabilities).
Why is Working Capital important?
Working capital is a critical measurement to any business. It’s an indicator of the ability to function efficiently to cover their daily operations. A shortage of working capital could result in serious consequences and can lead to financial alarm bells sounding as the ability to satisfy outgoing expenditure becomes an issue.
What determines the amount of Working Capital?
There are three factors which influence working capital:
Outstanding debts owed has a direct impact on the working capital and is therefore critical for companies to ensure the collection process is well functioned to avoid a long payment receivables period. Similarly, inventory levels need to be kept at the optimum level to positively impact on the working capital. Too much stock leaves a company vulnerable with no cash being received for the goods. Creditors (payables) also influence the working capital as the longer it takes vendors to be paid, the longer the company maintains its working capital used for expenditure. The period between payment to the supplier and receipt of customer funds is called the cash conversion cycle (CCC).
How do you improve Working Capital?
By focusing on these three components, a business can improve their working capital:
- Screening of (potential) customers on their payment behaviour and credit worthiness by requesting business credit reports and monitoring their financial developments as positions fluctuate.
- Critically examine the billing process. Taking a severe look at your invoice can have positive effects on receiving outstanding debts owed. Ensure that there are clear lines of communication between your sales and finance departments.
Learn how to improve the relationship here
- Improve the telephone techniques when collecting outstanding amounts.
Furthermore, there are other ways to improve your working capital including fees paid to receive monies quicker such as factoring or reverse factoring, optimising stock levels to suit market conditions and striking a longer payment period with suppliers.
Cash flow forecasting useful to Working Capital
Companies which focus on cash flow are likely to have good working capital measurements. Proactive practices of credit management enable an accurate forecast of cash flow knowing when payments are received and when suppliers need to be paid.
Calculation of Net Working Capital
Net working capital can be calculated as the ratio between current assets and current liabilities. Anything below 1 indicates negative working capital, while anything over 2 means that the company is not investing excess assets. It’s said that the optimum ratio is between 1.2 and 2.