Access to working capital is an important factor that impacts the overall cash flow of a business as well as the company’s capacity to manage day-to-day operations. For small and medium-sized enterprises (SMEs) in particular, working capital can have a big effect on their ability to grow over time and manage long-term debt.
We’ll explore what working capital is as well as discuss effective management strategies. Alongside careful planning, the UnLock Payment Gateway can help SMEs and other businesses leverage extended payment timelines, streamlining their working capital cycles.
What is working capital management?
Strong working capital management achieves two main advantages:
- It helps companies avert cash flow issues, increasing their liquidity and removing financial burdens that can hinder their operations and growth.
- It improves the business’s reputation in the eyes of potential investors and partners.
Essentially, working capital management is an effort to handle assets and current liabilities in a way that ensures invoices are quickly turned into cash, allowing businesses to meet their working capital needs.
Too many businesses are inhibited by inefficient working capital management. In fact, a 2017 study from PwC Australia found that lower-performing companies in the region may be able to achieve “a cash release of $90.6 billion from their balance sheets” if they improved their working capital management outcomes.
How do you calculate working capital?
There are a couple of different methods for calculating working capital, namely the working capital formula and the current ratio, otherwise known as the working capital ratio.
- The working capital formula: As defined by the Corporate Finance Institute (CFI), the working capital formula asserts that working capital is determined by subtracting current liabilities from current assets.
- The working capital ratio: This metric measures working capital as a proportion. To calculate this ratio, according to CFO Perspective, you must divide current assets by liabilities.
The working capital formula is a relatively simple method for determining net working capital. By contrast, the working capital ratio represents a company’s relative level of short-term financial strength in a way that is proportional to the size of the company. Both metrics allow you to assess whether your company is operating with negative or positive working capital.
In the working capital formula, negative working capital is measured as a negative number. For the ratio, this is represented as a value between 0 and 1. Positive working capital will have a positive number, according to the formula, or a value greater than 1 when calculated with the current ratio.
How do you control working capital?
Working capital management typically involves several strategies to help the business move from negative working capital into positive territory or to increase the current ratio even more. Often, this will involve:
- Adjustments in policies related to accounts receivable.
- Inventory management optimisation.
- Accounts payable modifications.
If it’s possible to maintain quality while increasing revenue and reducing expenses in the short term, those strategies will be beneficial, too. Often, though, when viewed through the lens of finance and accounting, controlling working capital is a matter of strategic cash management and inventory handling. Optimising the working capital cycle can also help, including by accelerating sales and expanding the payment window for settling accounts payable.
What is the working capital cycle?
According to CFI, the working capital cycle is the amount of time required for turning net working capital into a liquid asset, namely cash. This concept helps us understand that working capital is not a static concept. It’s circular. Effective working capital management requires not just a strong understanding of current short-term liabilities and assets but also a thorough knowledge of the working capital cycle. While positive working capital on a balance sheet is a good sign, there are limits to how far numbers on the page can take you.
The working capital cycle is closely related to another metric: the cash conversion cycle (CCC). This is a method of quantifying the average number of days between acquiring stock and converting inventory and accounts receivable into the cash needed for settling the accounts payable ledger. In other words, CCC measures the amount of time it takes you to pay back suppliers and to acquire new additional revenue that flows back into your working capital.
What are the sources of working capital?
As we’ve discussed, the main sources of working capital are relatively liquid assets like cash and inventory. The cash conversion cycle underscores the fact that some customer payments may lag behind. In these instances, invoices and the accounts receivable ledger may serve as an additional source of working capital.
If a small business struggles to achieve a negative working capital cycle — meaning they find it challenging to receive cash from their customers before they have to pay their suppliers — then the company may need to seek working capital finance assistance or other solutions. Some finance options that may be beneficial in this kind of situation include a line of credit or a working capital loan.
Types of working capital support that do not appear on the balance sheet
Working capital support can come in the form of an extended payment gateway that’s used for achieving an optimal cash conversion cycle. As a form of SME financing, such payment gateways can promote strong working capital management. These transactions are not recorded as liabilities on the balance sheet. Instead, they’re classified as account payable accounts.