Say somebody asked you right now, "Can you pay all your business bills for the next 12 months?" Would you be able to answer that question?
When you think about it, there are several factors to consider. You have to look at the cash you have on hand now, plus predict how much money you'll make in sales during that time.
Or, you'll need to look at a metric called working capital.
Let's dive in and see what working capital is and how you can manage it so that the answer to the above question is a "Yes!"
What Is Working Capital?
Working capital is the amount of cash and other current assets that remain after you've accounted for your current liabilities.
In other words, it measures the difference between what you have (cash, treasury bills, stocks, bonds, and inventory) and what you owe (salary expenses, taxes, portions of long-term debt, and other dues) in the next 12 months.
You may also hear working capital referred to as net working capital, and they are the same thing.
How Do Small Businesses Manage Working Capital?
The management of working capital involves selling inventory, collecting timely invoices, and optimizing short-term obligations.
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5 Working Capital Management Techniques to Use
These five techniques for working capital management will help you improve how cash flows in and out of your business, control costs, and collect your income faster.
Let's take a look.
1. Pay Suppliers on Time
At first, paying bills on time might seem like a backward way of managing working capital since the money is leaving your accounts. But this strategy is all about improving your vendor management and creating better relationships with suppliers.
When you consistently pay your bills on time, you help your vendors stay on top of their cash flow. As a result, you get a reputation as a good, reliable client, which enables you to create better supplier relationships.
Positive vendor relationships can help you negotiate better prices and ordering terms, such as discounts for buying in bulk.
One of the metrics to watch is your days payable outstanding (DPO), which is the number of days it takes you to pay your bills. You're paying early if your DPO is shorter than your supplier's payment terms.
One effective way to pay bills faster is to use electronic payment methods, like direct deposit or online credit card processing. This way, your vendors receive the money right away instead of waiting for you to mail a check.
2. Monitor and Control Costs
As a business owner, you're no stranger to the idea that "it takes money to make money." While that's true, there's a difference between smart business investments and unreasonably high costs that can eat into your profits.
The first step in controlling costs is to start monitoring them. You can start by creating a separate bank account for your business and investing in accounting software.
A business bank account makes separating personal expenses from operating costs easier. This way, you can monitor how money flows in and out of your business over time and understand your normal expense levels.
You can also invest in accounting software that helps you categorize expenses. This way, if you need to cut costs, you can start by looking at your high-spend categories.
3. Collect Customer Payments Faster
One of the best ways to increase your cash is by collecting invoice payments faster.
The first step to getting paid faster is sending out invoices on time. After all, if your customer doesn't receive their bill, they don't know how much to pay you. Invoice automation software can be helpful here because it lets you create invoices ahead of time and schedule them to send later.
You can also collect your money faster by accepting electronic payments, which are faster than checks in the mail. Electronic payments can also be faster than accepting credit or debit card information by phone because you're not waiting for your customer to find enough free time to call and make the payment.
Finally, you may consider options that encourage your customers to pay faster, such as choosing shorter repayment periods or offering discounts for early payment.
4. Improve Inventory Management
Inventory is an asset you can convert to cash by selling it, but before that happens, you have to purchase and store it.
If you have too much inventory on hand, your storage costs may get expensive. You may also have to reduce prices to move old inventory, which means less money coming into your business.
But, if your procurement process is off and you don't have enough stock to fill orders, you miss out on that income, and you may have customers that don't come back.
Here are some inventory management tactics you can use to improve your working capital:
- Check inventory levels regularly: This way, you know when you have too much or too little of an item, and you can adjust your purchases accordingly.
- Measure days inventory outstanding (DIO): Days inventory outstanding measures how many days an item sits in your inventory before it's sold and tells you about your inventory turnover rate—or how much inventory you sell in a given time. Ideally, you want a shorter DIO because it means you're selling and converting to cash faster.
- Improve the inventory turnover rates: Once you start measuring the DIO of your items, you'll see which products move fast and slow. Look at your slow-moving items and brainstorm how you can improve their turnover. For example, you may want to reduce the price or place the item in a more noticeable area of your physical or online store.
Consider using the just-in-time (JIT) inventory system, which means that you order items right before you'll need them to meet demand (instead of stockpiling inventory). This method helps you keep storage costs low and avoid the need to discount old inventory.
5. Make Smart Financing Decisions
If your inventory and accounts receivable aren't enough to cover short-term expenses, it's time to consider outside financing.
Short-term loans, sometimes called working capital loans, can help you pay your bills without committing to lengthy repayment plans.
Just make sure to compare the credit terms and interest rates of different providers to choose an option with lower total costs.
It may be better to open a new line of credit to continue paying your vendors on time and earn the long-term benefits of having positive supplier relationships.
Now that you know how to manage your working capital, let's go over how you calculate it.
How Do You Calculate Working Capital? (with Example)
You can use the following formula to calculate your working capital.
Working Capital = Current Assets - Current Liabilities
If you've ever looked at a balance sheet, you'll have seen these terms before. But what exactly do they mean?
In accounting, the term "current" means that you'll use up or pay for that asset or liability within one year. Here are some examples of what to include in each category.
- Prepaid expenses
- Accounts receivable
- Cash equivalents (treasury bills, treasury notes, certificates of deposit, etc.)
- Marketable securities (stocks and bonds)
- Payroll payable
- Accounts payable
- Accrued expenses
- Dividends payable
- Income tax payable
- Portions of long-term debts that are due in the next 12 months
Tools like Hourly payroll software can help you keep track of liabilities like payroll payable. But, as you can see, several factors affect working capital. The rest of this article will cover strategies to manage elements like your inventory and accounts payable.
Before we go there, though, let's look at an example of how to calculate working capital.
Working Capital Example
Let's say that you do the calculations and have the following assets and liabilities.
- Cash: $100,000
- Inventory: $350,000
- Accounts receivable: $50,000
- Total: $500,000
- Payroll payable: $20,000
- Accounts payable: $300,000
- Current debt payments: $50,000
- Accrued expenses: $50,000
- Total: $420,000
That means your working capital is $500K - $420K, which gives you $80K.
Ideally, you want to have a positive working capital because that means you have enough assets on hand to pay for your upcoming costs. If you have a negative working capital, you don't have enough current assets to cover your financial obligations for the next 12 months.
As a small business owner, it's up to you to monitor the financial health of your business and ensure you have sufficient cash to pay for your expenses.
What Are the Four Main Components of Working Capital?
The four main components of working capital are your company's cash, inventory, accounts payable, and accounts receivable. These are the main tools you can use to manage working capital and ensure a balance between short-term income and expenses.
Let's look at what each of these components includes.
- Cash: This is the money you have in your business accounts. It's your most liquid asset and can be used immediately to cover your bills or make debt payments.
- Inventory: Inventory refers to the products you have in stock you can convert to cash by selling to customers.
- Accounts payable: This is all the money you need to pay the suppliers. It includes payments for costs such as office supplies, raw materials, and housing inventory.
- Accounts receivable: This is the money you still need to collect from customers. In short, it's the amount you've invoiced but have yet to receive payment for.
At the basic level, working capital management means ensuring you have enough cash and short-term assets to cover upcoming costs.
What Are the Benefits of Working Capital Management?
- Improved cash flow: Cash flow is the flow of money in and out of your business. When you and your customers pay bills on time, there are fewer delays in your cash flow. This makes it easier for you to forecast your finances. For example, if you consistently pay your bills on the day you receive them, you'll know that money will leave your account on the day you're billed. The same goes for your customers. If they consistently pay within a week of receiving invoices, you can expect income to arrive within seven days of sending an invoice.
- More cash on hand: Also known as increased liquidity, this means that more of your assets are in cash, which can immediately be used to pay bills. This way, you don't have to wait until you sell inventory or collect invoices to have usable money.
- Increased profits: When you have more cash on hand, you can reinvest it in tools that help your business and profits grow. Not to mention, you also avoid fees for late payments.
- Less borrowing: Over time, positive working capital means that you don't have to take out as many loans, which means your interest costs will be lower.
- Better operational efficiency: Managing your working capital involves streamlining your day-to-day business activities, such as sending invoices and paying bills. Tasks don't pile up because of procrastination. By taking care of them in a timely manner, you operate more efficiently and free up time you can spend on winning new business.
Mastering Working Capital Management
Working capital is the difference between your short-term assets and your short-term costs. Ideally, you want a positive working capital because that means you can cover your expenses for the next 12 months.
Improve your working capital by paying your bills on time, making it easy for customers to pay you, and checking inventory levels regularly.
Now that you know what your company's working capital is and how to improve it, you can use the initiatives in this article to better manage cash, inventory, accounts payable, and accounts receivable.
Over time, taking these steps to improve your cash flow management can result in more efficient operations, fewer loans, and better profits.