What is Working Capital?
Working capital is the difference between current assets and current liabilities used to fund daily business operations. For a small to mid-size firm, working capital is vital to meeting payroll and paying bills. To optimize working capital, a simple rule of thumb is to pursue policies that help you get paid sooner, minimize your inventory requirements, and take longer to pay your bills.
Deep-Dive on Working Capital
Many organizations struggle to grow their business. Why? Often, they can’t generate enough cash from their operating cycle. This forces them to take on debt such as a bank loan or raise equity from outsider investors if feasible to finance the working capital they need for expansion.
But you can optimize working capital to free up cash and grow your business without new loans or outside financing. This involves strategies and policies to accomplish the following:
· Take longer to pay bills
· Develop a “terms optimization” program with early payment discounts
· Get paid sooner for the products and services you sell
· Reduce inventory requirements
Let’s examine this in more detail.
Obtain financing from your trading partners instead of your bank or other third-party sources.
This doesn’t mean asking a supplier or trading partner for money before you pay them. Instead, it involves paying attention to payment terms. In other words, take longer to pay your bills.
Few small to mid-size businesses negotiate payment terms with their suppliers. You might make payments to suppliers on receipt, or have payment terms of seven, ten or 14 days.
Extending payment terms to 30 days, 45 days, 60 days or even 90 days improves your working capital. It’s the equivalent of getting a bank loan or offering equity, but without the need to pay interest for this funding. And it makes sense when longer payment terms are standard for suppliers in that industry.
Offer early payment discounts to suppliers as part of a payment terms extension program.
This has benefits to the buyer and the seller. As a customer, would your supplier balk at your offer to extend payment terms? Then offer to pay them sooner than the new standard term, at a discount.
Supplier benefit: Gets cash sooner to improve cash flow
Buyer benefit: A lower price, plus a good cash return on that early payment. The interest rate on the discount is typically many times greater than what you could earn from a bank or short-term investment.
The key for buyers is to apply a payment terms extension program across all suppliers. This strategy for managing accounts payable actually improves your working capital.
Only a small portion of your suppliers will opt for the discount. The majority will accept the new, extended payment terms, freeing up working capital that you can use for your business.
Lower operational costs by reducing inventory requirements.
Tying up products in inventory can burden companies struggling with cash flow. Here are ways you can address that to optimize your working capital:
· Minimize the size of your inventory
· Increase your inventory turns
· Shift delivery expectations so you have less inventory waiting to be sold
· Get suppliers to finance your inventory until you sell it
Get paid sooner for the products and services you sell.
Earlier, we discussed extending payment terms with the suppliers you do business with. On the flip side, you can institute payment terms with your customers that have them pay you sooner.
Gaining more favorable payment terms from both your accounts receivable and accounts payable may be one of the most lucrative, yet overlooked, opportunity for the average business to optimize its working capital. Executing these working capital strategies can help strengthen your finances and make your business more profitable.
How Do You Calculate Working Capital?
The simple and most common way to calculate working capital, also known as net working capital, is to divide current assets by current liabilities. The result is the current ratio, which is a formula often used to gauge the health of a business.
A ratio of less than one, where liabilities exceed assets, is a sign of trouble, indicating a business may not have enough cash to pay its bills. Conversely, a ratio of 3 or above is not ideal. It could mean that you have excess cash balances. You could put some of that cash to work to fund business expansion.
While a healthy current ratio can vary by industry, a ratio of 1.2 to 2.0 is considered a reasonable target for most company. To know what’s best for you, compare your current ratio with other companies in your industry.
This is another ratio that compares current assets and liabilities to calculate working capital. It’s a more conservative way to assess a company’s financial health.
The quick ratio includes cash and cash equivalents, securities that can be easily traded, and accounts receivable as current assets. It excludes inventory (which can take a long time to convert to cash) and prepaid expenses (which can’t be applied to other liabilities).
For retailers with rapid inventory turns, the quick ratio would not be a good choice for calculating working capital. Inventory is essential to driving sales. Ignoring this asset in a working capital calculation would understate a retailer’s financial health.
There are other ratios you could use to further probe into your company’s financial health. The most practical relate to accounts payable, accounts receivable, and inventory.
Net Working Capital Formula Example
Let’s look at an example of calculating net working capital.
(Excludes land, other real estate, art, long-term financial investments , and other holdings that could not be turned into cash quickly.)
Accounts receivable: $85,000
Investments (short-term, redeemable for cash in less than a year): $25,000
Bank accounts (checking, savings, money market): $10,700
Pre-paid rent, insurance, other pre-paid expenses: $18,000
Total current assets: $208,700
Accounts payable: $30,000
Mortgage, lease, or rent payments: $25,000
Other short-terms loans (due within a year): $1,500
Employee salaries: $80,000
Accrued expenses: $8,500
Interest and fees on loans: $3,600
Total Current Liabilities: $148,600
Subtract Current Liabilities ($148,600) from Current Assets ($208,700), and this company’s current assets exceed current liabilities, yielding a positive working capital of $60,100. The current ratio is 1.40.
This ratio indicates that the company has sufficient working capital to cover operations. If current liabilities had exceeded assets, working capital would be negative, the current ratio less than 1, and the company would need to lower current liabilities or increase current assets to strengthen its working capital position.
What is Working Capital Management?
In this article, you have learned how you can monitor the components of working capital to maintain financial health and profitability, and improve earnings.
Bottom line: it’s hard to grow a business if you have poor working capital.
Earlier we described strategies for optimizing working capital by managing your accounts payable, accounts receivable and inventory. If you collect your receivables quickly, take a longer time to pay, and minimize your inventory, you can grow your business without needing more cash.
That is what working capital management is all about.
One working capital management approach doesn’t fit all businesses. In retail, for example, a supermarket may have 60-day terms with suppliers but turn their merchandise over every few days. That’s good working capital management.
Even better is the supermarket that can get suppliers to stretch terms to 75 days, which they could negotiate in exchange for expanding shelf space for a product line.
Conversely, the company with a high percentage of expenses in payroll may struggle to generate enough working capital through sales. It may require third-party financing for the working capital to operate the business.
For many companies, the more products sold, the less cash is available. That presents a working capital challenge.
But what happens when working capital grows with sales? Let’s look at two examples:
· Offers made-to-order computers online
· Purchases made by credit card
· Collects payment immediately with no inventory requirements
· Delays payment to suppliers until computers are shipped to customers
· Generates revenues from day one – no cash needed to grow the company
· Suppliers provide inventory
· Retailer collects payments immediately from online purchases
· Ships products in two or three days
· Has 60-day, 75-day, and 90-day payment terms with suppliers (with payment term date starting at product shipment)
· Daily revenues translate to an interest-free loan, funded by its suppliers
In both cases, an increase in sales improves working capital.
Few companies may be able to capture revenues immediately and delay payments to suppliers for months. Those who can, however, optimize their working capital for competitive advantage.
Importance of Working Capital
Working capital is the lifeblood of any business. You need it to fund daily business operations, cover expenses, and finance business expansion.
Working capital requirements can vary by industry. A manufacturer may need third-party funding for working capital since it generates revenues only after products are sold. The up-front funding allows the company to purchase the raw materials for production.
Conversely, retailers often delay payments to suppliers until the products they offer are sold. Inventory turns generate working capital, minimizing their need for third-party financing.
Can working capital requirements vary among companies in the same industry? Absolutely. Policies that affect working capital include how you manage collections and payments, your timing of asset purchases, the likelihood of customers defaulting on payments to you, and the need for inventory and how that changes by season.
It comes down to this: How you sell, how you pay for the goods and services to run your company, and how you manage your inventory affect your working capital.
With careful attention to those aspects of your business, you can grow your company without having to raise capital through debt or equity. Generate cash in your operating cycle, and you have the working capital you need to survive and thrive.