Working capital represents the money your company has to meet its day-to-day business expenses. It’s the amount of cash in your company’s pocket. Effectively managing working capital is critical to ensure your business can meet its obligations and avoid bankruptcy.
Working capital is calculated by subtracting current liabilities from current assets.
Yes, you want to have positive working capital, but the goal is to have $2 in current assets for every $1 of current liabilities. A company with a 2:1 ratio is effectively managing its working capital. A company with negative working capital is in serious and possibly immediate trouble, but any company with a working capital ratio of less than 2:1 could be in trouble.
To ensure your company has enough money to meet its daily financial obligations as well as to fund normal business operations, you must efficiently and effectively manage working capital. Too little working capital could lead to bankruptcy while too much working capital could lead to decreased profits and shareholder value.
Ways to Improve Working Capital
You can improve working capital by bringing it as close to the ideal 2:1 ratio as possible. Below are six strategies to improve insufficient working capital. Each of these strategies requires that you analyze a number of areas within your business to find ways to adjust processes and improve efficiencies in order to reduce expenses and increase positive cash flow.
1. Improve Accounts Receivables Collections
Are accounts receivable being collected in a timely manner? Encourage customers to pay on time by offering quick payment incentives. In addition, motivate your collections team (if you have one) with internal programs that offer incentives to collect outstanding invoices within the invoice payment terms.
2. Improve Accounts Payable
Negotiate better payment terms with materials suppliers and distributors (or replace them with new suppliers and distributors) and improve management of the payment process. You should review the payment terms on your accounts payable as well as the payment terms on your accounts receivable. Balancing these terms so your company is in the most favorable cash flow position is critical.
3. Negotiate Better Pricing with Suppliers
You should review all supplier contracts and negotiate better pricing whenever possible. If a supplier isn’t willing to negotiate more favorable terms for you, then you might need to replace them. Don’t let loyalty get in the way. This is your business, and you need the best working capital position in order to survive and thrive.
4. Reduce Expenses
Review your fixed and variable costs to determine if there are areas to improve cash flow. For example, office supplies, equipment, and technology all represent expenses that could be reduced with negotiations, new suppliers, and so on.
5. Segment and Analyze for Credit Risk
Analyze your customers and segment them by their likelihood to repay you. This will help to reduce collections and improve cash flow on an ongoing basis. You can also do this analysis for all of your distributors. Are specific distributors more likely to sell to customers that don’t pay than other distributors? Adjusting credit profiles and terms or adding penalties or incentives can reduce this risk.
6. Review Tax Opportunities
Is your company taking all of the tax breaks it can? Is it overpaying taxes? Review all current tax codes to ensure your company is always in the best tax position possible.
What if You Have Excess Working Capital?
If you have excess working capital, then you should be using it to generate an increase in profits.