What Is Working Capital?
Investopedia defines working capital:
“Working capital, also known as net working capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills), and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable.”
Working capital refers to the company’s liquidity. It allows you to support your business and pay its current operating expenses, generally raw materials, rent, taxes/duties, and personnel costs.
Completing the definition of working capital is a working capital requirement. This is the amount of cash needed to pay your expenses before the amounts owed by your customers are collected. To put it simply, working capital helps finance working capital requirements and is integral to financial safety margins.
The greater your working capital, the greater your financial independence.
Related: Working Capital and Why It’s Vital.
Working Capital Management
Management of working capital encompasses current assets and short-term liabilities. This dynamic process revolves around three types of activities:
Keep the working capital requirement to a minimum. Effective working capital management keeps a balance that maintains minimum levels of working capital without jeopardizing the continuity of the company’s operation. “Minimum levels” means that freeing up additional liquidity cannot lead to a shortage of stock, the late payment of strategic suppliers, or a loss of turnover due to an overly strict credit policy.
Maintain necessary liquidity. Effective working capital management requires optimal financing or placement of the working capital balance. The company can use several techniques to change its financing to match its real needs, immediately convert the sale of its products or services into cash, or obtain pre-financing based on contracts or invoices.
Manage all risks. Effective working capital management also consists of correctly controlling the multitude of risks inherent in the company’s operation: customer credit risks, currency risk, etc.
The overall health of the company depends on managing working capital efficiently. The working capital requirement makes it possible to optimize customer service and negotiate with suppliers.
Anticipate variations. To correctly manage your working capital requirement, you must accurately assess it and anticipate any changes. Thus, an increase in activity can lead to an increase in working capital. When orders increase significantly, the company also deals with a corresponding increase in expenses related to the increase in activity, often while not being paid until its product delivery.
Optimize customer follow-up. One key to limiting your working capital is to get paid quickly. That starts with prompt invoicing and includes sending systematic customer reminders, offering discounts for early payment, or specifying shorter payment terms for new customers to avoid unpleasant surprises. For certain activities, such as construction, it may also be wise to set up invoicing as the work progresses.
Negotiate, if possible, with suppliers. Ideally, management should optimize supplies to avoid receiving invoices too early and negotiate with suppliers to obtain more extended deadlines for payment. Realize that, in a concentrated supplier market, you may not have much room for maneuver. The more days of supplier credit you can negotiate, the lower your working capital requirement will be, with supplier credit being a “free” funding source. If your supplier offers you an attractive rebate for the cash payment of their invoices, do not hesitate to consider that option because it is generally more advantageous than a short-term bank loan.
Optimize inventory and supplies. You might also manage company inventory and supplies in such a way as to avoid surpluses and stretch supply flows as much as possible. Accountants can play the role of alert. Use tools to detect a drift on a particular stock line quickly. An accountant may also identify sources and tools for improving your working capital. This is one way to ensure the sustainability of your business.
Establish a strong banking relationship. All healthy organizations, even those with relatively low working capital, should establish lending options when working capital is tight. A business line of credit or working capital is a critical tool to bridge temporary periods where sales are strong. Still, customer payments have not been received, or suppliers need to be paid.
The Bottom Line
A company’s working capital is a core component of financing its operation. Analyze the company’s working capital and cash flow to determine and maintain the proper level of ready funds.
Increasing cash flow and working capital may not be good if the company borrows long-term debt but does not use it to generate enough cash flow to service amortization. Conversely, a sharp drop in cash flow and working capital might not be as bad if the company uses the proceeds to invest in long-term assets that will generate profits in the years to come.