Working capital is the capital available to a business to finance its day-to-day operations.
The accounting formula used to calculate it is:
Working Capital = Current Assets – Current Liabilities
Current Assets are all assets that a company expects to convert into cash within one year. These include:
- Cash and cash equivalents.
- Accounts Receivable. This represents money owed to the company by its customers for goods or services that have been delivered but not yet paid for.
- Inventory. This category includes a company’s raw materials, work-in-process goods, and finished products that will soon be sold for cash.
- Other assets. This includes stocks, gold deposits, bonds that are about to mature etc.
Current Liabilities are all financial obligations and debts that must be paid within one year. These include:
- Accounts Payable: This is the money the company owes to its suppliers, vendors, and other creditors for goods or services purchased on credit.
- Short-Term Debt: This includes debt payments that must be done within the next 12 months.
- Accrued Expenses: These are expenses that have been incurred but not yet paid. Common examples include wages payable to employees, taxes owed to government bodies, etc.
- Deferred Revenue: This represents advance payments made by customers for goods or services that the company has not yet delivered. It is a liability because the company is obligated to either provide the goods/services or return the money.
If the value of the Current Assets is higher than the Current Liabilities, then the company has a positive working capital, meaning it has sufficient capacity to pay its bills, fund operations, and invest in growth initiatives, etc.
However, negative working capital means the company suffers from liquidity shortages and might struggle to pay its debts and business partners.
Why it’s important to properly manage working capital
Companies that properly manage their working capital are in a much better position to take advantage of unforeseen business opportunities, such as purchasing raw materials while they are at a low price, buying equipment at a temporary discount, etc.
Companies with a healthy amount of working capital can also move faster than their competitors when the need arises.
For example, companies with a lot of working capital can complete contracts faster by outsourcing certain tasks and doing more work in parallel.
By comparison, companies with little working capital have much more limited work capacity. These companies will often move slower since they need to wait for more cash payments to afford buying more services, tools, or hire more employees.
8 Methods to properly manage working capital
There are quite many tried and tested strategies companies can use to improve their working capital.
Depending on the method, the purpose is to increase the amount of current assets, or decrease a company’s current liabilities.
Accelerate payments from customers (accounts receivable management)
The objective of accounts receivable management is to convert sales into cash as quickly as possible.
Usually, this means establishing standard operating procedures for finding trustworthy customers, making payments easy, creating payment schedules etc.
The most impactful change is to perform credit evaluations on potential customers to understand their ability to pay.
This information lets companies properly calibrate what kinds of services they can offer to new customers, and what payment options they can extend.
Another option is to configure an efficient and automated invoicing system. Invoices should be sent immediately after delivery of goods or services. Invoices must also be accurate, clear, and easy to understand, with payment terms, due dates, and payment instructions prominently displayed.
Manual follow-up on outstanding invoices is time-consuming and inefficient. Modern accounting or account receivable software can automate this process by sending automated reminders for both upcoming and past-due invoices.
Managing accounts payable
The goal of accounts payable management is to increase how much cash is available at any given time by optimizing when payments are made.
In general, a business should hold onto cash for as long as it is contractually and strategically possible.
Businesses should also renegotiate payment terms whenever possible, for example by extending the payment deadline or asking for discounts for large orders.
Another solution is to properly automate the payment process so that invoices are paid on time, and without incurring late payment fees or other similar penalties.
Better inventory control
For many businesses, inventory is often the largest component of working capital and managing it effectively is critical to freeing up trapped cash.
A common solution is to adopt a Just-In-Time philosophy. JIT means that a company orders materials from suppliers only when needed in the production process.
This approach dramatically reduces the amount of inventory held, thereby minimizing storage costs, waste, and the amount of cash tied up in stock.
The disadvantage is that it requires excellent forecasting and seasonal inventory analysis.
Another common strategy is to optimize how much backup inventory to keep for unexpected demand or supplier delays.
Finally, businesses should identify and dispose of “dead” inventory as quickly as possible, before it completely loses its value.
In this context, dead inventory refers to items that are obsolete, have expired, or are no longer in demand. This inventory represents a complete loss of the capital invested to purchase it.
Existing dead inventory should be disposed of through discounted prices.
To prevent more such inventory accumulation in the future, companies should do regular audits to find which products sell poorly and adjust how many are ordered.
Implement a Device-as-a-Service model
Device-as-a-Service (DaaS) is a device ownership model where businesses procure, manage, and finance their devices (such as laptops or phones) through a subscription instead of purchasing them.
In short, DaaS is a monthly subscription that provides an individual device (such as a laptop or smartphone) plus device management services (acquiring the device, configuring it, repairs, warranty claims etc.) plus a software layer to monitor and manage the device.
A DaaS model helps companies improve their working capital in three ways:
First, it prevents large initial capital expenses when buying devices, and transforms them into smaller, monthly expenses that can be cancelled at any time.
Secondly, a DaaS subscription is classified as an operational expenditure, meaning it can be deducted immediately, which can lower tax expenses in the short term.
Thirdly, a DaaS provider takes on many responsibilities of a company’s IT department, meaning device repairs, warranty claims etc.
This can mean cost savings by avoiding the need of an IT department, or productivity increases since the IT department can focus on more profitable tasks.
We at INKI are one of the biggest Daas providers in Europe and have extensive experience with this.
This DaaS model has greatly helped LEGO, one our clients, to be more agile and cost effective.
Negotiate discounts with early payments
Companies with strong cash reserves can use them to negotiate discounts from suppliers by offering early payments to suppliers in exchange for a discount.
Generally, the larger and earlier the payment, the bigger the negotiated discount can be.
Another way of looking at it is that the buyer company uses its excess money to invest in the supplier, in return to reduce its Cost of Goods Sold (COGS).
Invoice factoring and financing
Invoice factoring is a financial mechanism where a company sells its accounts receivables to a third-party financial company, known as a factor, at a discount.
The factor typically provides a large percentage of the invoice’s face value (e.g., 70-90%) to the business upfront. The factor then takes over the collection process from the customer.
Once the customer pays the full invoice amount to the factor, the factor returns the remaining 10-30% balance to the business, minus the factor’s fees.
For businesses with long customer payment cycles or those experiencing rapid growth that reduces their available cash, invoice factoring is a financial tool that can provide an immediate and significant injection of working capital.
Factoring directly converts a non-liquid current asset (accounts receivable) into the most liquid asset (cash).
This immediate infusion of funds can be used to meet payroll, purchase inventory, or fund daily operations, preventing a liquidity crisis and enabling the business to pursue growth opportunities without being constrained by slow-paying customers.
Cash flow forecasting
Accurate and regular cash flow forecasting is the practice of anticipating future cash inflows and outflows, allowing a company to anticipate when cash is needed the most.
Companies with good cash flow forecasting will run their business by managing cash-intensive periods, rather than responding to crises.
Effective forecasting involves gathering data from across the organization, meaning including sales departments, accounts receivable, accounts payable schedules, and planned operational expenses, to build a comprehensive model of future cash positions.
Modern financial planning and analysis (FP&A) software can automate much of this process, using real-time data from ERP systems and leveraging AI and machine learning to improve forecast accuracy.
When done right, cash forecasting allows management to identify potential cash shortfalls far in advance, giving them time to arrange for financing or adjust spending.
It also identifies periods of cash surplus, enabling the company to plan investments or to arrange early payments in exchange for discounts.
Without a solid forecast, a business is blind to its future financial situation, and risks falling into liquidity shortages.
Short term financing and credit lines
Even with the best management practices, businesses may still face temporary working capital shortfalls.
A simple solution for this is short term financing tools such credit lines or business loans.
The most common tool for this purpose is an unsecured, revolving line of credit from a bank.
This provides a flexible source of capital that a company can draw upon as needed to cover temporary needs, such as funding a seasonal inventory build-up or managing cash flow during a large project.
A working capital line of credit ensures that a business can always meet its short-term obligations, even during periods of tight cash flow.
However, it is crucial that this short-term financing is used for its intended purpose. A common business mistake is to use a line of credit to purchase long-term assets like machinery or real estate.
This creates a dangerous mismatch between the short-term nature of the financing and the long-term nature of the asset, tying up the credit line and leaving it unavailable for day-to-day operations.
