Cash flow is the amount of capital a business has made over time. In contrast, working capital is a current snapshot of how much cash a company has. Working capital management involves checking a company’s assets and liabilities for maintaining adequate cash flow to cover short-term operating expenses and liabilities. It includes tracking various metrics such as working capital ratios, recovery and inventory rates. This post explains why working capital is vital for the survival of your business.
What is Working Capital?
Working capital is the difference between a company’s current assets and liabilities. A company’s working capital is positive if its current assets are higher than its current liabilities. However, if the assets are less than the current liabilities, the company’s working capital will be negative.
You can use working capital to finance large capital projects over several years, unlike investment capital or long-term capital. Additionally, working capital can be used to pay for day-to-day expenses, take a business loan on the property, and purchase raw materials to manufacture the company’s products. You can cover your daily expenditures through working capital even if the company is service-oriented and does not manufacture products. However, instead of buying raw materials, working capital is used for labour costs and other expenses necessary to maintain operations.
What Do You Mean By Working Capital Management?
Working capital management is a business plan helping the companies use working capital effectively and retain enough cash flow for meeting meet short-term targets and commitments. By improving working capital management companies can free up cash stuck on their balance sheets. As a result, you can reduce your need for external borrowing, grow your business, fund mergers and acquisitions, and spend in research and development.
Working capital is vital for any business health, and improving its position improves a company’s operational efficiency, but managing it efficiently requires a balance. Companies must have enough cash to cover planned and unanticipated costs while maximizing the use of available funds to fuel growth. It is achieved by effectively managing accounts payable, accounts receivable, inventory, private commercial finance, and cash.
How Does Seasonality Affect Working Capital?
Businesses affected by seasonality need better working capital planning and discipline. For example, suppose your company’s sales spike toward the end of the year and into the summer. It creates peaks and troughs in inflow throughout the year. How do companies manage this cash flow volatility while managing the operating cycle? At the end of the year, when sales recover, working capital gets filled with cash. It should generate more cash than the company needs in the same period.
The company already knows that sales will surge again in the summer. During low sales periods, companies can hoard cash because they have fewer employees and generally fewer expenses. At this late stage, the company begins an operational cycle to build product inventory for the upcoming summer season. You can use the cash intensively to fund the operating cycle. By accumulating cash during peak business hours and using it during off-season operating cycles, the company can manage the working capital better.
Primary Components of Working Capital Management
Working capital management is further classified into several key components.
1. Manage Liquidity
Proper cash management ensures an organization has sufficient cash to meet its usual business needs. It is also important because it can affect the company’s financial health and contribute to its success or failure. When a company’s assets get tied up in illiquid assets, it can struggle to maintain efficient cash flow and service fast business loans in Australia.
2. Accounts Payable Management
Accounts payable refers to the amount a company owes its suppliers and is a record as a liability on the company’s balance sheet. Accounts payable management is essential to maintain efficient working capital. Late payments can result in penalties and fines and affect the company’s creditworthiness. In some cases, non-payment can result in the forced liquidation of assets to pay back creditors. Managing debt and ensuring timely payments are chief elements of working capital management.
3. Inventory Management
Inventory is a company’s primary asset used to generate sales. Investors see inventory turns as a clear indicator of a company’s marketability and purchasing and manufacturing security. Low inventory levels indicate the business is at high risk of losing sales, while inventory levels that are too high may indicate inefficient use of working capital.
4. Accounts Receivable Management
Accounts receivable is the balance owed by the debtor to the company. If a company has trouble getting cash from its borrowers, it may suffer liquidity problems. You can commonly use the recovery rate to compute the standard time it takes for a business to receive payment after a credit sale.
5. Treatment of Short-Term Debt
Similar to liquidity management, short-term cash management should focus on ensuring that an organization has sufficient liquidity to monetize its short-term investments without incurring significant risk. Efficient handling of private commercial finance requires the appropriate funding mechanism selection and access to the size of the funds at all times.
End Verdict
By understanding and forecasting the operating cycle, business owners can accurately budget working capital. In other words, controlling your working capital products is essential to your business’s success.