It is virtually impossible to run a successful business without a continuous supply of cash that is easily accessible. Here is why understanding your company’s working capital is pivotal to creating a powerful organization.
Management teams tend to focus on the profit and loss statements or P&L, which is a formidable picture of what has already happened. However, managing your cash flow requires you to predict the future consistently. If not, cash flow quickly becomes a stratified problem that can have devastating consequences.
This article will discuss working capital definitions and concepts you can implement in your business to improve cash flow management and reduce volatility and future financial stress.
What Is Working Capital?
Working capital or net working capital (NWC) is the difference between current assets and current liabilities. A liquid asset can be bought and sold quickly without affecting its price.
Current assets, such as cash, securities, inventory, and accounts receivables, are resources a company owns that can be used up or converted into cash within one year.
Current liabilities are the amount of money a company owes. Examples of liabilities include debt repayment, accounts payable (bills due), and operating expenses due within the year.
In its most basic form, working capital is part of your cash flow management approach.
NWC can be both positive and negative. The amount an organization needs to run smoothly varies depending on the size of the business and the industry. Of course, the more working capital a company has, the better its financial position. However, this number changes over time.
Retailers, for example, will see higher working capital during the holiday season when sales are at their highest. During these same months, a pool manufacturer will likely have lower liquidity to run their business.
Financial industries will frequently lend money to organizations during these off-peak periods. This movement of funds often requires tight monitoring between the company’s management team and the bank itself.
Businesses watch both their accounts receivable and accounts payable to help forecast future earnings. A shortfall occurs when the amount of money owed by the company is greater than the revenue coming in.
Mistakes to Avoid
Having positive NWC is the objective as the company will not need to borrow money. At the same time, an organization doesn’t want too much cash or liquidity. Excessive working capital means funds remain idle, which aren’t earning a profit for the business.
Regular, high NWC could be used to increase social media marketing or other marketing strategies, provide additional training, or purchase software that could increase efficiency.
Lastly, and perhaps the most severe working capital mistake is not having a proper cash flow management system in place. Although it may seem to be a good idea to pay bills as soon as they come, you may want to hold off until more invoices are paid. The consequence of paying a bill too soon might mean not having enough money for next month’s inventory or payroll.
Tips to Improve
Since NWC is current assets minus current liabilities, there are mainly two ways to improve your working capital. A business can increase existing assets or reduce liabilities.
A business can also tweak the dates that invoices are due. Companies can offer incentives to their customers to collect the receivables sooner. Conversely, an organization may negotiate a debt extension with creditors or suppliers.
Once you have a solid cash management process in place, you will be able to determine the best course of action for new spendings. For example, in the long run, it might be cheaper to buy inventory in bulk; however, after plugging in the numbers, you may determine this would be sacrificing too much valuable working capital, which may result in inadequate NWC to package and ship.
Working capital is one of the most critical metrics to running a business. Insufficient EWC amounts to a shortage of resources and even layoffs. At the same time, too much liquidity could mean the company is not reinvesting its money to improve the business.
Most businesses fail, not because of a lack of profits, but because of poor EWC management. Cash flow management is critical, and the sooner you can initiate a consistent process, the more flexibility you will have to expand and grow.
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