Profits alone don't always keep a business running; it's the working capital that ensures continuity. Some businesses operate without profits, while others might shut down despite having them. External financing can provide necessary working capital, but mismanagement can lead to unrecoverable debt. Therefore, managing working capital effectively is absolutely key for business success. It helps to reduce overdependence on external funding, optimise capital usage, and maximise outcomes.
Considering the essential nature of working capital and its management, this blog will explore:
- What is working capital?
- What is working capital management?
- Importance of working capital management
- How to calculate working capital?
- Crucial working capital metrics to monitor
- Effective strategies for capital management
- Optimise working capital management with OneAdvanced
What is working capital?
Working capital represents the funds available to finance and sustain the operations of a company after removing current liabilities from their current assets. It indicates the company's liquidity or the liquid funds available to fulfil payment obligations and sustain operations.
As a metric, it provides a quick peek at the short-term financial health and efficiency of the organisation.
Components of working capital
The two major components are:
Assets classified as current comprise items that are easily liquidated into cash or are intended for consumption within a year, like cash, inventory, accounts receivable, prepaid expenses, and other short-term assets.
- Current liabilities
This refers to the money a company owes. It includes accounts payable, wages payable, debt instalments, taxes, and even advance payments for goods or services yet to be delivered.
Types of working capital
The types of working capital can be broadly split into the following two:
Gross working capital
This refers to all the current assets of a company, reflecting the total liquidity available to the business without considering its short-term liabilities.
Net working capital
This is the amount available to the company after deducting current liabilities from the gross working capital.
Other types include:
- Permanent working capital
This refers to the minimum amount of current assets a company will always need to fulfil short-term obligations and carry out operations seamlessly.
- Regular working capital
An element of the permanent working capital that is assigned to the fulfilment of day-to-day operations.
- Reserve working capital
Another portion of permanent working capital, set aside for emergencies and unpredictable events.
- Fluctuating working capital
This type adjusts with business activity (e.g., inventory costs) unlike fixed costs (insurance). It reflects the variable expenses a company can control based on production and sales decisions.
What is working capital management?
In simple terms, working capital management is the process of effectively controlling a company's operational capital to achieve optimal operational efficiency and financial health. It involves managing current assets and liabilities to optimise cash flow, fulfil short-term obligations, and contribute to the long-term goals of the company. The process includes cash management, accounts payable and receivable management, inventory management, and short-term financing.
Importance of working capital management
Without adequate funds, businesses cannot maintain critical operations such as bill settlements, payroll processing, and stock procurement. Consequently, proficient working capital management is vital. It upholds the equilibrium between current assets and debts, guaranteeing steady cash flow for meeting immediate financial commitments. It enables timely supplier payments, efficient inventory control, and prompt order fulfilment, nurturing a positive reputation and customer contentment.
Effectively managing capital propels growth efforts like business expansions, product launches, and market entries, minimising reliance on external funds and preserving financial equilibrium. Besides supporting daily activities and growth projects, it also ensures the availability of cash reserves for unexpected incidents. This is crucial for risk management, lowering insolvency risks and providing a safety net against sudden financial challenges or market shifts.
By ensuring businesses have the resources they need, effective working capital management not only helps them to survive today, but also thrive in the future.
How to calculate working capital?
Calculating the net working capital amount is a straightforward deduction of current liabilities from current assets.
Working capital formula
Working capital = Current assets – Current liabilities
Example:
Consider a company has £200,000 in current assets and £100,000 in current liabilities.
Using the formula, it will be:
Current assets – Current liabilities = Working capital
£200,000 – £100,000 = £100,000
This means the company currently has £100,000 available as its working capital.
A net positive value from the calculation indicates the company has enough funds to meet short-term debts and could have leftover cash if necessary. In contrast, a negative result indicates insufficient funds, which may signal liquidity issues and difficulties in meeting debt obligations.
Crucial working capital metrics to monitor
Monitoring various metrics such as cash flow and inventory is essential for efficiently managing finances. This is often achieved by referencing various ratios such as:
1. Working capital ratio
Working capital ratio is also known as the current ratio. It is obtained by dividing current assets by current liabilities. It serves as an indicator of the company's financial condition. A ratio below 1 highlights a situation where short-term debt exceeds assets, potentially causing challenges in meeting immediate financial obligations. The ideal range for this ratio is between 1.2 to 2.0. However, a ratio exceeding 2 suggests that the company might not be effectively leveraging its assets to boost revenue.
2. Days Sales Outstanding (DSO)
It is also called the collection ratio. DSO represents the average time a company needs to collect payment after a sale on credit. This metric highlights the efficiency of managing accounts receivable.
3. Days Inventory Outstanding (DIO)
DIO calculates the average time a company takes to sell its full inventory. It reveals how long inventory is stored before sale. A lower DIO means faster turnover and more effective inventory management.
4. Inventory turnover ratio
This is calculated by dividing the cost of goods sold (COGS) by the average inventory balance during a specific period. This metric showcases the frequency at which a company cycles through its inventory, balancing sales and restocking activities. A higher ratio often indicates proficient inventory management, while a ratio falling short of industry norms may signal operational challenges requiring resolution.
5. Days Payable Outstanding (DPO)
The DPO figure denotes the average number of days a company takes to finalise its accounts payable, covering payments to suppliers for credit-extended goods and services. This crucial measure evaluates how well a company handles its payable duties and oversees cash flow requirements.
6. Cash Conversion Cycle (CCC)
CCC serves as a vital indicator to gauge a company's proficiency in managing working capital. It is the measure of the average duration for a company to convert investments in inventory and accounts receivable into cash earned from sales. A lower CCC showcases efficient capital management, highlighting quick cash retrieval from customers and accelerated inventory-to-sales turnover.
Effective strategies for capital management
Effective working capital management is a balancing act. Having too few funds can restrict operations, while an excess can mean unutilised resources and potentially limited profitability. Therefore, it necessitates effective management of various internal factors and the implementation of smart strategies, such as:
Cash flow management
Cash flow is a critical component of working capital, making its effective management essential. It encompasses the tracking of cash flow, trend analysis, and the implementation of strategies to optimise cash movement. This management practice is essential for financial stability, avoiding cash shortages, and making informed decisions for both current and future financial goals.
Cash flow forecasting
Cash flow forecasts predict the cash demands a company will likely have in the coming period. These insights are valuable for proactive financial planning, enabling businesses to handle liquidity needs effectively. By producing accurate cash flow forecasts, organisations can optimise their reserves for operational expenditures and financial obligations. Additionally, this practice prepares companies to manage unexpected cash flow disruptions and make informed decisions about investments and resource allocation.
Enhancing accounts payable and receivable efficiency
Effective management of accounts payable and receivable is essential for maintaining working capital. Proper management of accounts payables helps companies utilise favourable payment terms, thus maximising cash flow retention, whereas efficient accounts receivable processes minimise outstanding invoices (lower DSO) and enhance liquidity. Successful management is indicated by key metrics like a low DSO and a high accounts payable turnover ratio. Improving the efficiency of these processes can boost cash flow, optimise working capital, and strengthen financial health. Automation of invoices and electronic payments are valuable technological solutions for this purpose.
Inventory management
Surplus inventory ties up funds that could be utilised for revenue generation, while shortages may cause delays and discontent among customers. These scenarios can detrimentally affect working capital, which is why maintaining the right inventory level is critical. Effectively managing inventory aids in optimising levels, cutting lead times, and minimising holding expenses, all while ensuring sufficient stock to meet customer needs.
Effective debt management
While debt funding can propel business towards growth, its careful management is indispensable. Excessive debt can strain a company's financial health, directing a significant portion of resources towards debt servicing, potentially limiting operational capabilities and disrupting cash flow. Inadequate debt control poses insolvency threats. Hence, a well-defined debt management plan is vital to maximise working capital efficiency.
Risk management
For protecting the business's cash flow, it is imperative to engage in risk management to both identify and mitigate financial risks. It also shields against unpredictable risks like market volatility and economic changes by implementing necessary contingency strategies. By adopting this forward-thinking approach, the company can sustain optimal working capital reserves.
Business asset management
Proper business asset management is vital for effective capital management. It optimises resource utilisation, minimises costs, and helps extend asset lifespans, maximising return on investments. It ensures that both current and fixed assets are used efficiently to generate revenue and support operations, allowing businesses to better utilise cash tied up in underutilised assets, thereby enhancing working capital. Strategic investments in assets such as technology upgrades or process improvements further drive long-term efficiencies and cost savings.
While these strategies are vital, it is also important to continuously monitor and adjust them. Regularly check financial metrics and performance indicators to evaluate the effectiveness of your capital management efforts and respond to market changes, regulatory shifts, or business developments.
Optimise working capital management with OneAdvanced
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The software automates tasks such as accounts payable processes, reducing manual work and enhancing operational efficiency. Renowned for its efficient and robust reporting capabilities, Financials provides automated, real-time reports that deliver crucial financial insights effortlessly. This feature is particularly valuable for strategic initiatives such as forecasting, budgeting, and making informed business decisions.
Financials' extensive functionality facilitates the effective management of various aspects of working capital, supporting businesses to sustain and scale their operations.