What is working capital management?
Working capital management, which is defined as current assets less current liabilities, is a business tool that allows companies to make the most of their assets and still have enough cash flow to meet short-term goals. Companies can make use of working capital to free up cash that might otherwise be stuck on their balance sheets. They may be able to reduce their need to borrow externally, grow their businesses, finance mergers and acquisitions, or invest more in R&D.
Although working capital is vital to any business’s health, it can be difficult to manage effectively. Companies must have sufficient cash to cover unexpected and planned costs while making the most of their funds. This can be achieved through the efficient management of accounts payable, accounts receivable, inventory, and cash.
The formula for working capital
The current liabilities are subtracted from the current assets to calculate working capital. This means that the working capital formula could be represented as:
Working capital = current assets – current liabilities
Current assets are assets like cash and accounts receivable. Current liabilities include accounts payable.
The following are other important metrics for working capital:
- Days Sales Outstanding – The average time it takes for customers to pay their invoices.
- Days Payables Outstanding – The average time it takes for a company to pay its suppliers.
- Days Inventory Outstanding – The average time it takes for a company to sell its inventory.
- Cash Conversion cycle (CCC ) – the average time it takes for a company to convert inventory investments into cash.
Objectives of working capital management
Businesses should pay close attention to working capital. It is the amount of capital that they have to make payments or cover unexpected costs. This helps to ensure that the business continues to run as normal. But working capital management can be complicated. There are many objectives to a working capital program.
The business should ensure sufficient liquidity to meet its short-term obligations. This can be done by collecting payments from customers earlier or by extending payment terms for suppliers. Unexpected costs may also be considered obligations and should be included in the working capital management approach.
Optimizing capital performance
Another goal of working capital management is to maximize capital utilization – either by minimizing capital cost or maximizing capital returns. To achieve the former, you can reclaim capital that is tied up in order to reduce borrowing. The latter requires that spare capital has a higher ROI than the average cost of financing it.
Growing the business
Those are the basics It’s important to make the most of your short-term assets, whether you are investing in R&D or supporting global expansion. Your company may not be as financially sound if its assets are entangled in inventory and accounts payable. This means that a cautious approach to managing working capital is not optimal.
Effective working capital management
While speeding up the CCC may improve a company’s working capital position and be beneficial for its financial health, it could also have negative consequences. You could lose your ability to fulfill orders if inventory levels are reduced.
DPO means that your accounts payable are also your suppliers’ accounts receivable. If you pay suppliers later than expected, you could be increasing your working capital at the expense of your suppliers. This could have a negative impact on your supplier relationships and make it more difficult for cash-strapped vendors to fulfill your orders on schedule.
A company’s effective working capital management means that you take steps to improve its working capital without having any adverse effects on other suppliers. You might reduce your DSO by creating more efficient billing processes that allow customers to receive their invoices faster. It might also mean implementing an early payment program to allow suppliers to receive payment sooner than usual.
Working capital management solutions
There are many options available to companies for supporting effective working capital management both for themselves and for their suppliers. These solutions include:
Companies can submit electronic invoices to receive working capital benefits. You can streamline the invoicing process to reduce errors and automate manual processes. This will ensure that customers receive their invoices as soon as possible. This could help you get paid faster. Companies can submit electronic invoices electronically to convert purchase orders into invoices or send large volumes of invoices via system-to-system integration.
Cash flow forecasting
Companies can forecast future cash flows, such as payables or receivables, to plan for cash shortages and make the best use of cash surpluses. The better you can forecast your cash flow futures, The better informed your decisions regarding working capital management, the better.
Supply chain finance
Supply chain finance, also known as reverse financing, is a method of offering buyers early payment through one or more third-party funders. Suppliers can increase their DSO by being paid earlier and at a lower cost of funding. Buyers can also preserve their working capital by paying according to agreed terms.
Dynamic discounting is another solution that buyers can make early payments to suppliers using this option However, there is no external funder as the program is funded entirely by the buyer through early payment discounts. This allows suppliers to lower their DSO, much like supply chain finance. It also allows buyers to get attractive, risk-free returns on excess cash.
Flexible funding providers may also be available to buyers. They can move seamlessly between supply chain finance models and dynamic discounting models. This allows companies to adapt to changing working capital requirements while still supporting their suppliers.