Working capital allows your business to grow without incurring debt. Demonstrating positive working capital makes getting loans or other forms of credit easy.
Working capital refers to the difference between a company’s current assets and current liabilities (per the balance sheet). The amount the business requires to make regular payments, purchase material to produce goods, and cover unforeseen costs. That amount differs from company to company, industry to industry. In short, a company needs working capital to meet short-term obligations and to fund operations.
Both inadequate and excess working capital may negatively impact a company’s financial health and operational ability. While inadequate working capital may lead to bankruptcy, excess working capital may result in the underutilization of resources.
What Is Excess Working Capital?
Every company needs a certain level of working capital to fund operation, and the capital above that required amount is excess working capital. This means the company’s current assets exceed its current liabilities. Excess working capital may be due to a combination of high assets and low liabilities, making the determination of non-operational working capital even more difficult.
Working capital requirements differ from industry to industry and even between entities within the same industry. So, what might be excess working capital for one company is not for another. Seasonal businesses are excellent examples in this scenario. They require different amounts of working capital to operate during different times of the year.
Managing Working Capital
Both inadequate and excess working capital are harmful to the company. Management of working capital ensures the company’s financial health and profitability and involves managing its three significant elements:
- Accounts receivable
- Accounts payable
Accounts receivable represent the past sales amount owed to the company by its customers and debtors. The company must collect this amount promptly to meet its short-term operational needs. This revenue appears on the asset side of the balance sheet but becomes an asset only after the company collects it. Analysts use the metric day’s sales outstanding to determine the average number of days the company takes to collect its accounts receivable (sales revenue).
Accounts payable refers to the amount the company must pay in the short term to maintain positive credit ratings and sustain good relationships with its suppliers and creditors. Companies try to maintain a maximum cash flow and balance accounts payable with accounts receivable by delaying payments as long as possible. Most companies usually have a shorter average time to collect accounts receivable than their average time to settle accounts payable.
Inventory converts into sales revenues, and efficient inventory management measures the company’s success. Prospective investors/buyers use the inventory turnaround rate to gauge the company’s sales, manufacturing, and purchasing strength and efficiency. Inventory turnaround rate refers to the rate at which the company sells and replenishes its inventory. While excess inventory shows wasteful use of working capital, low inventory increases the risk of losing sales.
An imbalance between these three significant elements of working capital management results in inadequate or excess working capital within a business.
How Excess Working Capital Harms Your Company
Unused funds and lower returns to investors. Because it is not needed to sustain company operation, this money is unused (i.e., not generating revenue) and may drop share prices. Business owners can divert this excess money toward productive aspects for better revenue-earning potential or increase investors’ return and share value in the capital market.
At times, the company may have borrowed funds to run the business smoothly and pay the interest. By maintaining excess working capital, the company neglects to reduce the loan principal while paying that interest, which further damages the company’s financial health.
Reduced management efficiency. Excess working capital leads to the complacency of the management team—the money’s always available—which reduces the management team’s efficiency. The presence of excess funds invites overspending or speculative activities, risking financial losses. Mismanagement of funds leads to strained relationships with banks and other financial institutions. Ultimately, investors lose confidence in the management team’s ability to handle finances, and goodwill drops.
Inventory overstock and bad debts. The excess availability of cash (excess working capital) may also lead to unnecessary purchases of inventory that must be stocked. This increases risks for mishandling, waste, theft, and other losses. The spending spree may also result in additional debt. That, combined with a lack of interest in the timely collection of payments (accounts receivable), leads to an increase in debt and an overall decrease inefficient operation.
Credit policy. Excess working capital tempts management to adopt a liberal credit policy. They might allow long credit periods on sales of goods to less credit-worthy customers who cannot pay. They might even fail to make consistent follow-ups on unpaid invoices.
Turnaround ratios. Excess working capital destroys the control of performance ratios, such as working capital ratio, inventory turnaround ratio, collection ratio, etc., which help conduct business efficiently. It also ruins other related benchmarks used to make the decisions for running the business.
Business sales proceeds. In an M&A transaction, it is difficult to convince a prospective buyer that the business does not need the excess working capital currently present. A buyer wants to benefit from the maximum amount of working capital which negatively impacts the amount the business owner could extract from the company when the transaction concludes.
Run a Tight Ship
Adequate working capital ensures your company runs smoothly and grows its value, enabling you to meet your short-term operational expenses while investing the company’s assets productively. While the determination of adequate working capital is subjective and varies from company to company, you can determine the optimum level of working capital for your unique business and implement systems to manage it. Working capital management involves maintaining the balance between accounts receivable, accounts payable, and inventory.
Guidance from expert advisors will help you maintain adequate working capital to keep your company ship-shape.
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