What Is Working Capital Management and How Does It Work?

What Is Working Capital Management and How Does It Work?

What Is Working Capital Management and How Does It Work?

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  • Working capital management is a strategy for making sure your business is operating efficiently in its short-term, day-to-day operations. 
  • Working capital is the tally of your  current assets and liabilities, and tracking them helps you make sure they’re being well utilized. 
  • Management of accounts receivable, accounts payable, and inventory are all parts of working capital management.
  • Learn why proper management of a company’s working capital is essential for small business owners and how to incorporate it into your business plan.

Why Is Good Working Capital Management Important?

Managing your working capital, also called net working capital, gives you confidence that you have enough cash on hand to cover what you owe to keep your day-to-day operations running smoothly. You probably already do this in a number of ways, but it’s good to get an understanding of the technical reasons it matters and ways you can improve.

Working capital management includes management of the following:

  1. Liquidity: How quickly a business’s assets (shares, money market accounts, inventory, accounts receivable) can be converted into cash.
  2. Accounts receivable: Money that is owed to your business.
  3. Inventory: The products and raw materials needed to create those products your business is ready to sell.
  4. Accounts payable: Money your business owes to creditors.
  5. Short-term debts: Obligations your business must pay within the next year.

The ultimate goal of effective working capital management is to balance your business’s growth against its profitability and liquid assets. A company’s cash on hand can tell you a lot about its overall financial health and its operational efficiency, which is why it’s such a necessary part of running a business — small or large.

Benefits of Managing Working Capital Well

Managing working capital gives you a birds-eye view of how liquid your business is, how efficient it is, and how financially healthy it is in the short term.

Maintain the right liquidity

Liquidity means your ability to turn your assets into cash to spend. These assets can include cash in checking accounts, company shares, inventory, unpaid invoices or accounts receivable, and money in money market accounts. Keeping the right liquidity in your business means that you’ll be able to cover all your short-term debts and still be able to function as a business. While there is such a thing as too much liquidity — you don’t want all your current assets to be liquid — you need to have enough liquid assets on hand to manage an emergency. Managing your working capital can ensure you maintain the right amount.

Increase efficiency

Working capital management allows you to keep your business’s operating cycle, also called cash conversion cycle (CCC), efficient. In other words, you’ll calculate how much time it takes for every dollar you put into your business to pass through production and sales to become cash received. You can take this information and use it to your business’s advantage.

Managing working capital can improve cash flow by revealing areas where you’re not working efficiently. Your business may be taking on too much debt, taking too long to convert its sales into cash, or may not be keeping the right amount of inventory on hand.

Achieve better financial health

Working capital management gives you more control of your business’s financial health. You can ease up cash flowing to areas that aren’t working in your interest and make sure you have enough cash to cover the cost of goods and services your business needs.

Tracking and identifying any areas of weakness is one of the main objectives of working capital management. In this way, working capital management allows for forecasting potential trouble. Identifying risks lets you address them by improving your operational efficiency before they cause larger issues. 

Working Capital Formula

To calculate the amount of working capital you have on hand, you’ll use simple subtraction, which you’ll record on your balance sheet. Subtract your business’s current liabilities (or short-term debts that have to be paid within the year) from current assets (or short-term assets you can turn into cash in under one year). 

Working Capital = Current Assets – Current Liabilities

There are three ratios that come into play in working capital management:

  • Working capital ratio: Also called the current ratio, it calculates how many times over your business can pay off its debt with its current assets, which provides a clearer picture of financial health than a simple dollar amount of working capital. It provides a measure of a business’s liquidity.
  • Inventory turnover ratio: This ratio measures how quickly your inventory is selling and being replaced to ensure you’re maintaining the right amount of inventory — not too much but not too little.
  • Collection ratio: Also called days sales outstanding, it analyzes how well your business handles its accounts receivable by telling the average number of days it takes to collect on a sale.

For more, see our detailed guide explaining the working capital formula and how to calculate it for your business.

Ways to Manage Working Capital 

There are several methods you can use together when managing working capital for your business.

1. Maintain inventory levels

Inventory management is one of the most important pieces of the working capital management puzzle. If you have too much stock on hand, you’ll likely be low on cash that you could use elsewhere. But if your stock is too low, you may not be able to fill orders, which can hurt sales and the trust you have built with your customers — a fact that is especially true given the current supply chain disruptions. Keeping your inventory level just right allows you to fulfill orders but not have waste.

2. Track when you pay vendors

Paying vendors on time is essential, but when you pay them is equally important. Days payable outstanding means your payment is past due — and many vendors don’t allow you to do this post-pandemic. Paying on time strengthens the vital relationship with your vendors that may ultimately bring you better payment terms, credit terms, or interest rates. On the other hand, if you opt for early payment, you might be using up too much cash that could have served you better if used for another purpose, so there is a balance.

3. Upgrade your receivables system

There are a few changes you can make to your receivables management system to improve your working capital. First, make sure you send out invoices immediately — and figure out where the problems are if you’re struggling to do so. Delayed invoices push back the entire payment process, so your money takes longer to get to you. Additionally, make sure the invoices you send out are correct. Look to your invoicing process if you’re running into inaccuracies with your invoices that go out.

4. Review customer contracts

You need to make sure money is coming in in a timely manner. Look through your contracts with customers who take out debt to see if you’re extending too much credit or giving them too long to pay it off. These factors can hurt your business’s cash flow. Going through this check regularly is a big part of working capital management. Performing thorough credit checks on potential customers can help you lower the number of bad debts you take on. 

How Managing Working Capital Improves Relationships With Financial Providers

Positive working capital proves that a business can pay off its short-term obligations easily — and is only one of many metrics that investors and lenders consider when determining the health of a business. If you’re considering looking at working capital loans or other small business loans for your working capital needs or to make capital investments, you’ll want to make sure you are making the right impression on lenders. Establishing and building your business credit score is a great first step.

See Nav’s guide on how to find working capital for more ideas on procuring working capital. 

Best Accounting Software for Working Capital Management

Tracking your working capital involves knowing exactly how much of your money is coming and going at all times. Accounting software simplifies the process of keeping track of all your accounts. These options come with built-in financial statements that you can download at the click of a button. You have enough on your plate — accounting software can take care of the math for you.

Here are several online accounting options we recommend looking into to see if they would fit your business needs.

Bench

Online Bookkeeping by Bench

Bench is the online bookkeeping service for business owners. As a Nav member, you get 30% Learn More

Bonsai

Bonsai: Freelance Accounting Software

Bonsai’s all-in-one product suite with smart automation lets you focus on your passion, not Learn More

FreshBooks

FreshBooks: Small Business Cloud Accounting Software

The best cloud based small business accounting software. Send invoices, track time, manage receipts, expenses, Learn More

Intuit QuickBooks Pro

Pro Small Business Accounting Software by Intuit

QuickBooks Pro makes accounting easy - with tools to organize your finances all in one Learn More

Sage

Sage Accounting

Sage aims to transform the way people think and work, enabling organizations to thrive. Every Learn More

1-800Accountant 

Find an Accountant with 1-800Accountant

1-800Accountant is ideal for small businesses. Our dedicated team of experienced accounting professionals and Learn More

How Nav Can Help

No one should feel alone in their small business journey — so consider Nav your partner in all things small business. Sign up with Nav and add your business details securely gives you the small business tools you need instantly. You’ll get things like actionable insights into your business’s cash flow, business services, and the real-time funding options you’re most likely to qualify for. We’re here to help you make your next move.

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