How to Improve Working Capital Management in Your Business
Payday is fast approaching, and you need to restock inventory to fill a large order. Unfortunately, your customer isn’t due to pay their invoice for 30 days, and you have a few other customer payments outstanding. Even though business is booming, you just don’t have the cash on hand to cover your immediate expenses. If this scenario sounds familiar, you may need to optimize your working capital management strategies.
In this article, you’ll learn what working capital is, why effective working capital management matters, and how to improve the financial management of your business so you can plan ahead with confidence.
What Is Working Capital?
Working capital is the money your business has available to cover its short-term obligations. You calculate it by subtracting your current liabilities from your current assets.
Working Capital = Current Assets – Current Liabilities
If your short-term assets are greater than your short-term liabilities, you have positive working capital. Positive working capital keeps your business running smoothly, ensures you can meet short-term obligations, and provides a buffer against unforeseen financial challenges.
If your short-term liabilities are greater than your assets, you have negative working capital. This can quickly lead to cash flow problems and leave your business unable to pay its bills, take on new projects, or qualify for loans.
Your main short-term assets are:
Accounts receivable: How much your customers owe you
Inventory: Raw materials, work-in-progress, and finished goods that you can sell
Cash and cash equivalents (liquid assets): Money your business has in its checking and savings accounts and assets that are easy to turn into cash, like stocks, ETFs, and Treasury bills
Your main short-term liabilities are:
Accounts payable: How much you owe your suppliers
Customer deposits: Cash you’ve already taken from customers on goods and services they haven’t received yet
Short-term debt: Debt the business owes that you must pay back within the current accounting period, like bank overdrafts and short-term business loans
Long-term debt: The part of any long-term debt, such as mortgages or equipment loans, that needs to be repaid in the next year
Accrued expenses: Money your suppliers haven’t invoiced you for yet
Dividends payable: Payments to shareholders that have not been made
Taxes payable: Money you owe to federal, state, or local authorities, like sales tax and payroll tax
Wages and salaries payable: Wages that you’ve not yet paid to your employees, including commission and bonuses
What Is Working Capital Management?
Working capital management ensures you maintain enough cash and liquid assets to pay your bills and take advantage of opportunities to grow your business.
There are three approaches to working capital management:
Matching approach: Also known as a hedging approach, the matching approach to working capital management aligns the funding duration to the specific expense or asset being paid for. Long-term investments like real estate are paid using long-term financing methods such as a loan, while short-term expenses are covered by revenue or with short-term financing.
Conservative approach: A portion of operational expenses and short-term costs are financed with long-term sources of revenue. This keeps more liquidity available day-to-day to keep the business agile in the face of market changes. Excess cash may also be invested in short-term securities, which are in turn sold when funds are needed.
Aggressive approach: With this approach, you keep only a small amount of funds available short-term. Only funding to cover the current expenses is maintained, and there is limited financial flexibility for changes in capital requirements. During seasonal peaks or periods of growth, short-term financing or other funding infusions bridge the gap.
No matter the approach you take, the goal stays the same: maintaining operations, spending as little as possible to achieve goals and quality standards, and maximizing return on any investments. All this adds up to the work being done and the revenue being earned.
One way to measure how well you're doing is with the working capital ratio. This shows how many times your current assets can cover your current liabilities:
Working Capital Ratio = Current Assets ÷ Current Liabilities
For example, if your business has $400,000 in current assets and $250,000 in current liabilities:
$400,000 ÷ $250,000 = 1.6
A ratio above 1 means you should be able to cover your short-term debts comfortably. A ratio under 1 suggests you may struggle without bringing in extra capital.
How to Manage Your Working Capital Better
To better manage your working capital, use the strategies mapped out below within the following areas:
Accounts receivables
Accounts payable
Inventory
Cash
Short-term financing
Each one has a direct effect on your company's ability to meet short-term obligations and fund future expansion.
Accounts Receivable
Slow-paying customers drain your cash flow and make it harder to meet day-to-day business needs. You could be making record sales, but if you’re not getting paid fast enough, your company may struggle to stay on top of everyday costs.
To improve accounts receivables in your firm, employ these strategies:
Run a credit check on customers: You may want to reserve extended payment terms for customers with good credit and a history of meeting their financial obligations. For example, a standard invoice might have net 30 terms, but you’ll extend net 90 terms to customers with excellent credit.
Provide clear credit terms on invoices: Make due dates and potential late fees clear on invoices and provide customers with multiple payments options. For example, you may accept payments via credit card, check, or B2B buy now pay later.
Send out invoices as fast as possible: If invoices are being sent late, it takes longer to get paid. Invest in accounting software that allows you to send invoices quickly and automate payment reminders.
In order to determine potential areas of improvement, monitor these key accounts receivable metrics:
Days sales outstanding (DSO): This is the average number of days it takes to collect payment from your customers after you’ve invoiced them. The lower your DSO metric, the better.
Receivables turnover ratio: This is how efficiently you collect payments from customers. To get this metric, divide your net credit sales by your average accounts receivable. You can also use the ratio to determine your average duration of accounts receivable.
Overdue receivables ratio: This is the percentage of accounts receivable that are unpaid and overdue. A lower percentage points to efficient payment collections, while a higher percentage suggests inefficient collections and the potential for cash flow troubles.
Accounts Payable
Paying your bills on time keeps your suppliers happy, prevents late fees, and helps you optimize your company’s working capital.
Here’s how to improve your accounts payable management:
Improve your procurement process: Negotiate favorable payment terms with vendors and suppliers to make sure you’re getting a fair deal. Also, consider consolidating the number of suppliers and vendors you work with. This means fewer bills to juggle and may lead to discounts due to bulk deals or bundled services.
Stick to your agreed payment schedule: Pay suppliers on time and in full, and they may be more likely to offer you priority service or flexible credit terms. You may even secure discounts with early payments, reducing your cost of goods sold and improving your profitability.
Automate your invoice approvals and payment schedules: Use accounting software to remind you when, who, and how much you have to pay so you avoid late payments. You may even be able to streamline your accounts payable further by setting up autopay.
Build a strong payment history: Many suppliers report their client’s payment records to commercial credit agencies. Paying on time can improve your business credit score, which helps when you need funding.
Have clear spending policies: With the proper policies and approvals in place, you can keep unauthorized spending and redundancies at bay.
Keep an eye on the following metrics to improve your working capital management:
Days payable outstanding (DPO): This is the average number of days you take to pay suppliers. A high DPO suggests you’re hanging onto your cash well, but if it’s too high, that might be a sign of payment delays. The lower this metric is, the more likely suppliers will approve and extend credit accounts.
Accounts payable turnover ratio: This measures how efficiently you repay your creditors over a period of time. To calculate it, divide your total supplier credit purchases by average accounts payable. The higher the ratio, the faster you’re making payments. Lower ratios may suggest cash flow issues.
Discounts captured: Find out what savings you’re missing out on by not taking advantage of all the early payment discounts some suppliers use as an incentive. To work out this figure, divide the total value of discounts you’ve used by the number of discounts you’ve been offered.
Inventory Management
Inventory management is a key factor in your operational efficiency — in other words, how well you use resources like cash to keep costs down, reduce waste, and improve results.
If you carry too much inventory, you’ll spend more on storage and risk losing money on stock you can’t sell. But if you have too little inventory, you may turn away customers and miss out on sales.
To get inventory levels right, consider investing in:
Demand forecasting software: Use software to help you decide how much stock to buy. Many apps are now able to predict seasonal fluctuations in sales, so you can plan ahead and avoid overstocking or stockouts.
Inventory management software: Keeps track of what you actually sell and can trigger re-orders if stock falls below a certain amount. This will help you prevent buying too much stock in slow-moving items, so you only invest in inventory you’re likely to sell.
Find potential room for improvement with following inventory management metrics:
Inventory turnover ratio: This is the number of times you sell and replace your stock in a year. A higher ratio means you’re better at predicting what stock customers want and selling it to them.
Number of days inventory is held: This is the average length of time goods sit on your shelves before being sold. The faster you sell them, the better your cash flow.
Cash conversion cycle (CCC): This is how long, in days, it takes to turn the money you’ve spent on stock into cash from sales.
Cash and Liquid Assets
Cash is the foundation of any business’s financial stability and flexibility. If you don’t have enough cash to meet your financial obligations, you’ll struggle to pay staff, landlords, suppliers, taxes, and more.
Here are two strategies for managing your cash:
Check your cash position daily: Make real-time cash management something you do every day. Keep a close eye on your cash position daily, not just at month-end. Your aim should be to have enough cash in the bank to meet your immediate costs.
Invest your surplus cash: Make cash you don’t need for daily operations work for you by parking it in low-risk short-term investments, like Treasury bills or money market funds. That way, it’s earning a return but still easy to access if something unexpected comes up.
Monitor and improve the following metrics to stay in more control:
Current ratio: This is the value of your current assets divided by your current liabilities. A ratio above one means you should be able to cover your short-term debts.
Quick ratio: The quick ratio is like the current ratio, but it doesn’t include inventory as part of your current assets. Think of this like a tougher test of your liquidity, as it measures how quickly you can pay bills using just your cash and cash equivalents.
Short-Term Financing
Another way to manage cash flow is to use short-term financing to cover working capital needs and operating expenses.
Used strategically, funding options like business lines of credit or working capital advances can provide you with the financial flexibility you need to run your business efficiently.
Here’s how you can use financing wisely:
Be sure you can afford it: Have a clear plan for how you’ll use the funding and when and how you’ll pay it back.
Shop around: Take into account interest rates, repayment terms, withdrawal flexibility, and fees, so you can reduce the cost of capital. Also, consider the approval process and how quickly you can access funds when you need them.
Treat financing as a cash flow tool: Use short-term financing to bridge temporary dips in cash, not to cover ongoing shortfalls. For larger investments or sustained expansion, go for a longer-term loan option instead.
Monitor these metrics to manage your short-term debt well:
Debt service coverage ratio (DSCR): Divide your operating cash flow by your short-term debt payments. If you score more than one, it means you’re not overstretched.
Interest coverage ratio: Take the interest payments that are due on all short-term debt for the next 12 months and divide your earnings before interest and tax. Less than 1.5 means you may struggle, and more than three means you can comfortably cover the interest payments.
Short-term debt to total debt ratio: If your short-term debt is 40% or more of the value of your long-term debt, then you may be relying too heavily on short-term borrowing, which could harm both your cash flow and ability to invest in longer-term growth.
Practice Good Working Capital Management for a Brighter Business Future
There is an old saying in business which states, “Turnover is vanity, profit is sanity, cash flow is reality.” It’s still true today. Managing your working capital well means keeping tight control of accounts receivables, accounts payables, inventory, cash reserves, and short-term financing. Do this and you’ll protect your cash flow and give your business more room to grow — even when the unexpected happens.
Backd is a leading provider of commercial finance. Strengthen your working capital position with two of our competitive funding options:
Working capital advance: Access between $25,000 and $2 million (minimum one year in business required).
Business line of credit: Borrow between $50,000 and $750,000 (minimum two years in business required).
To be eligible for our lending solutions, you must be based in the U.S., have established business credit, and have a brick-and-mortar address. You’ll also need a minimum revenue of $100,000 a month and a credit score of 650 or more.
Apply now and receive an approval in as little as 4 hours.
