Improving Working Capital
Maintaining the right level of working capital is often the key challenge for business growth. A lack of working capital cripples your ability to grow your business. On the other hand, having too much available working capital can be a sign that money isn't being reinvested in the business, meaning that opportunities for growth are being wasted.
Why is working capital important?
Without enough working capital your business can't meet its operating costs - making it a struggle to pay suppliers or staff, or causing you to put off maintenance or ordering new stock. Often it's businesses that are growing successfully that have the biggest problems with working capital - as sales grow it becomes increasingly more difficult to pay suppliers and order in enough materials to keep up with larger orders before all those new sales turn into cash inflows.
On the other hand, skillful management of working capital is often seen by potential lenders and investors as a sign of a management team that's functioning well; meaning that it's easier for you to access new sources of funding and fuel further growth.
What is working capital?
Working capital is the difference between your current assets;
- cash in your current accounts,
- the money your customers owe you,
- the value of your stock and your work in progress,
and your current liabilities;
- any overdrafts or similar short term borrowings,
- the amounts you owe your suppliers,
- accrued expenses (such as wages, bank interest and tax that you haven't paid yet),
- the portion of any long term borrowings that you have to pay back within the next 12 months.
How to measure the health of your working capital
The amount of working capital you need depends on the size of your business (if you doubled your operations, without any other changes, you would need twice your current level of working capital). There's a simple measurement for benchmarking your working capital, regardless of the size of the business - the working capital ratio.
This is calculated by dividing your current assets by your current liabilities.
- A ratio between 1.2 and 2.0 is considered a healthy working capital, and a key indicator of well managed business operations.
- A ratio less than 1.0 needs immediate attention, to avoid constraining growth or ending up in financial distress.
- A ratio above 2.0 is also considered bad - it creates concerns that you have a weak strategy, so don't know how to invest your surplus cash, or that you lack the operational capability to deliver investment opportunities.
The working capital ratio is a useful measure but doesn't tell the full story about the qualify of your working capital management. That's because it doesn't differentiate between different types of current assets or current liabilities. For example these two companies may end up with the same working capital ratio:
- The first company may have most of it's current assets in cash, and most of it's accounts payable not due for 90 days.
- The second company may have the same total current assets, but this mostly comprises a large amount of slow moving stock. Likewise it has the same current liabilities, but large invoices due in the next 30 days.
Despite having the same working capital ratio, the first company has much stronger working capital.
To get a fuller picture, you have to measure the quality of the different components within your working capital:
- Dividing average accounts receivable by net sales per day measures your "days sales outstanding" - on average the amount of time it takes to turn customer debt into cash income.
- Dividing average stock level by cost of sales per day measures your "days inventory outstanding" - on average the amount of time it takes to turn your stock into sales.
- Dividing accounts payable by cost of sales per day measures your "days payables outstanding" - on average the amount of time you take to pay your invoices.
Good working capital management involves keeping track of these quantities as your business grows, and using them to measure effectiveness as you implement new and improved working capital management processes.
How to improve your working capital
There are a number of steps you can take if you need to increase your working capital:
Improving your accounts receivable
Excelling in credit management is critical for any business selling goods or services on credit. Prompt payment, in full, for all of your sales underpins your working capital. This is a big topic in it's own right so see our free guide to credit control for more advice.
Even with exemplary credit control procedures, there's more you can do to improve your accounts receivable:
- Could you reduce your credit terms, if not in general then for some customers? How much cash would this free up, and how much would this reduce your borrowing costs? Could you pass some or all of that saving onto your customers to incentivise them to agree to shorter payment terms?
- Have you looked into debt factoring, invoice discounting? This type of asset based finance may be more cost effective in improving your working capital than your current overdraft or other short term borrowings. Why not download our free guide to business funding to find out more?
Improving your stock and work in progress
Good inventory control free's up the amount of working capital you have tied up in stock. Having the systems you need to measure your stock accurately allow you to order goods just in time. Manufacturing business that invest in their production processes are able to hold less work in progress while still meeting demand. Businesses that have high quality forecasting get the balance right between surplus stock eating up their working capital vs lost sales from not having the stock you need.
Improving your accounts payable
Improving supplier relationships is key to better credit terms and improved working capital. Paying your suppliers when due (and not before) ensures you're seen as a reliable credit worthy customer.
- Making electronic payments in place and having high quality technology systems lets you automate much of your work, saving you time and hassle while reducing the risk of overlooking payment because of other time pressures.
- As with inventory mangement, high quality forecasting helps immensely - this time by making sure you have an accurate forecast of cashflow. Good cashflow forecasts warn you in advance if cash is tight and lets you put steps in place to avoid missing a payment.