Working capital is calculated by taking the difference between the current assets (such as cash, stock inventory and accounts receivable) and current liabilities (such as accounts payable and loans). Businesses use working capital to fund their daily operations. As a result, this working capital is essential to every properly functioning business.
Without working capital, a business cannot sustain its current activities let alone take action to grow. By contrast, a large amount of working capital allows businesses to meet existing expenses and commit to additional ones, even in times of financial instability. The amount of working capital a business has is, therefore, a primary indicator of business health, which wise business leaders do not neglect.
How to optimise and improve working capital
The most common way to optimise and improve working capital is to reduce the length of the business’s working capital cycle. This cycle refers to the time it takes for a business’s assets to ‘become cash’. This is calculated as a number of days by adding together the timeframes for inventory turnover and debtors turnover and then subtracting creditors turnover. The longer the working capital cycle, the longer capital is locked up in the operational cycle without yielding much return.
To reduce your business’s working capital cycle, you can focus on improving any or all of the following contributing factors:
1. Collection of receivables
Taking actions that result in getting paid faster is a key method of reducing the length of the working capital cycle. You could consider offering discounts or other incentives for prompt payment. And if you haven’t already done so, centralising accounts receivable processing can also help.
Reducing the length of your payment terms may have a big impact on how fast you can collect your receivables, however, it may not be the effect you desire. Doing this risks alienating existing customers and pushing away new ones. Selling unpaid invoices is usually a more effective means of getting access to accounts receivables at an earlier date.
2. Inventory cycles
Minimising your inventory cycle may be another avenue for reducing your business’s working capital cycle. Lean manufacturing and just-in-time production are generally both effective means to this end.
3. Payment terms
If you can negotiate longer payment terms for your own bills, this will also improve your working capital cycle length. You’ll get the best results if you seek to start these negotiations with suppliers that are more likely to be able to afford an increase.
Take a look at each part of your working capital cycle and assess whether you can make improvements. If you’re still facing cash flow challenges after that, it may be time to consider alternative financing.