All business owners face the epic challenge of growing their business while having enough cash to fund product development, expand sales and marketing, or hire additional staff. The key to success lies in having positive working capital, which provides excess cash to invest in growth. To quote an industry maxim: “Revenue is Vanity, Profit is Sanity and Cash is King” — Alan Miltz.
How to Ignite Your Company’s Growth With Working Capital provides the insights, strategies, and metrics needed to plan for and achieve growth successfully.
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- 5 ways effective working capital management contributes to faster growth
- What 5 metrics help boost working capital management
- 10 best practices to improve accounts receivable and working capital
- How an effective accounts receivable strategy helps optimize cash flow
- What 3 key factors determine how much working capital a small business needs
- 5 ways effective working capital management contributes to faster growth
- How much working capital does a small business need?
- Why calculate working capital?
- What is a good working capital ratio?
- 5 Metrics that help boost working capital management
- Why improving your Cash Conversion Cycle (CCC) is crucial to your company’s growth
- How can optimizing accounts receivable help boost working capital?
- Best practices to improve accounts receivable and working capital
- How Plooto accelerates accounts receivable while ensuring cash flow continuity
- How can you use working capital financing in your business?
5 ways effective working capital management contributes to faster growth
Effective working capital management enables a company to:
- Keep operating and meet its business obligations, including payroll, operational expenses, supplier payments, and other short-term obligations.
- Fund growth without taking on any external additional debt that comes with interest costs.
- Improve its credit worthiness, making it easier for a company to obtain loans and other forms of credit.
- Earn short-term profits, enabling the company to put excess funds into short-term investments.
- Earn reputation and goodwill, making it easier to obtain contracts and negotiate favorable terms with suppliers.
How much working capital does a small business need?
Three key factors determine whether a company requires significant working capital: business type, operating cycle, and management goals.
Businesses that deal with physical inventory — such as retailers, wholesalers, and manufacturers — often require large amounts of working capital to operate efficiently. Retailers and wholesalers must buy pre-made inventory for sale to consumers or distributors. Manufacturers need to acquire raw materials to produce their inventory in-house. Seasonal businesses may require extremely high working capital during certain parts of the year as they prepare for their busy season.
Businesses that provide intangible products or services, such as consultants or online software providers, generally require much lower working capital. Companies that have matured and are no longer looking to expand rapidly also need less working capital.
Why calculate working capital?
Working capital is a financial metric that helps you plan for future needs and ensure the company has enough cash and cash equivalents to meet short-term obligations.
How to calculate working capital
Working capital is calculated by subtracting current liabilities from current assets, as listed on the company's balance sheet. Current assets include cash, accounts receivable and inventory. Current liabilities include accounts payable, taxes, wages, and interest owed.
Does working capital change?
For most companies, working capital fluctuates. While the balance sheet captures its value at a specific moment in time, several factors can influence this value. These factors include large outgoing payments and seasonal fluctuations in sales.
Positive vs negative working capital
Positive working capital can be a good sign of short-term financial health: the company has enough liquid assets remaining to pay off short-term bills and to internally finance the growth of its business.
Negative working capital could mean the company’s assets aren’t being used effectively, possibly creating a liquidity crisis. Even if a company has made investments in fixed assets, it will face financial and operating consequences if liabilities are due. Lack of liquidity could result in:
When negative working capital does work
Some businesses can be successful even with negative working capital. These businesses generate cash quickly due to high inventory turnover rates and receiving prompt payment from customers. Therefore, they require little working capital.
On the other hand, capital-intensive companies that manufacture heavy equipment and machinery typically cannot raise cash quickly because they sell their products on a long-term payment basis. If they are unable to sell products fast enough, cash may not be available during financial downturns. As a result, having adequate working capital is essential.
What is a good working capital ratio?
The average working capital ratio is 1 — meaning that for every $1 of current liabilities, you have a $1 in current assets. A working capital ratio of between 1.5 and 2 indicates solid financial stability, and usually shows that assets are being used properly.
A working capital ratio of less than 1 suggests potential liquidity issues, while a working capital ratio of more than 3 could mean that assets aren’t being utilized properly.
5 Metrics that help boost working capital management
Days Sales Outstanding (DSO)
DSO represents the average number of days it takes credit sales to be converted into cash or how long it takes a company to collect its accounts receivable.
Days Sales Outstanding = Accounts Receivable/Net Credit Sales)X Number of days in period
What it means: A high DSO number indicates that a company is experiencing delays in receiving payments, which can cause a cash flow problem. A low DSO indicates that the company is receiving payments quickly.
Days Inventory Outstanding (DIO)
DIO measures the average number of days that a company holds inventory before turning it into sales.
Days Inventory Outstanding = (Average inventory / Cost of sales) X Number of days in period
What it means: The lower the figure, the shorter the period that cash is tied up in inventory. In general, a decrease in DIO is an improvement to working capital.
Days Payable Outstanding (DPO)
DPO is the average number of days between the time the company receives an invoice and when the invoice is paid. DPO is typically calculated on a quarterly or annual basis.
Days Payable Outstanding = Accounts Payable X Number of Days/Cost of Goods Sold (COGS)
What it means: DPO is a key cash-flow metric that indicates how well a company manages its cash outflows.
Working capital as a percentage of sales
Working capital as a percentage of sales is a liquidity and activity ratio that informs a business how much of every dollar is needed to cover operational expenses and short-term debt obligations. For instance, if the working capital is 40 percent of sales, then 40 cents of every sales dollar is required to fund the working capital cycle.
Working Capital as a Percentage of Sales = Working Capital / Gross Sales X 100
What it means: Working capital as a percentage of sales measures how well the company is utilizing its working capital to generate revenue.
Cash Conversion Cycle (CCC)
CCC is a metric that expresses the time (measured in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales. CCC takes into account how much time the company needs to sell its inventory, how much time it takes to collect receivables, and how much time it has to pay its bills.
What it means: CCC is one of the best ways to check the company’s sales efficiency. It helps the firm know how quickly it can buy, sell, and receive cash. A good cash conversion cycle is a short one. A low CCC low means your working capital is not tied up for long and your business has greater liquidity.
Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
Why improving your Cash Conversion Cycle (CCC) is crucial to your company’s growth
Optimizing internal processes can extract working capital that is "trapped" in the cash conversion cycle (CCC). The CCC is the time required to convert cash outflows associated with production into cash inflows through the collection of accounts receivable.
These funds can then be recycled back into the business, directly impacting the bottom line. By freeing up this cash, the business can grow because working capital that was previously being used to fund an inefficient process can now be invested to help the organization achieve its strategic objectives.
How can optimizing accounts receivable help boost working capital?
Successful and sustainable businesses operate with optimal working capital. A haphazard approach to the accounts receivable process can lead to dissatisfied clients, delayed payments, and underutilization of working capital.
So it is essential to have a productive accounts receivable strategy in place to optimize cash flow. A company must collect its receivables promptly to use those funds to meet its debts and operational costs. Although accounts receivable appear as assets on a company's balance sheet, they only become assets once the company collects them.
Optimizing accounts receivable increases liquidity, which enables a business to improve its performance, reduce debt, and aid growth.
Best practices to improve accounts receivable and working capital
- Centralize the primary data collection and management process to ensure that customer account information is accurate.
- Implement a transparent approval process for extending credit.
- Optimize the billing process to promote higher accuracy and faster delivery of invoices.
- Know how much you have in outstanding receivables by creating a consolidated and actionable view of your accounts receivable within one system.
- Offer several payment methods to make it easier for customers to pay you.
- Utilize technology to put your accounts receivable process on autopilot and eliminate inefficiencies.
- Touch your customers well before the term and with multiple reminders to ensure you receive payments per your terms.
- Track Days Sales Outstanding (DSO); Days Inventory Outstanding (DIO); Days payable outstanding (DPO).
- Proactively ask your customers if they received the invoices, if the invoices are clear and accurate, and consistent with contract terms.
- To help assure you get paid:
How Plooto accelerates accounts receivable while ensuring cash flow continuity
Plooto simplifies and automates cash flow management through a single, integrated AP/AR platform. This platform allows you to easily view, track, and manage the entire cash flow cycle.
Plooto supports multiple payment collection options, including credit card, recurring payments, and pre-authorized debit (PAD) payments. Recurring payments and PADs accelerate payment collection, ensure cash flow continuity, and increase visibility into cash flow forecasting.
Electronically sent payment requests also save you the effort and time spent sending invoices by email or postal mail. It also eliminates the need to collect payments through third-party vendors or banks that do not reconcile with your accounting software. In addition, auto-email reminders notifying customers of upcoming payments reduce the risk of late payments.
To improve your accounts receivable, you need to think of it in broader terms. You need to think of AR as a process that is part of the entire sale and the sale is not complete until you get paid.
Accounts Receivable is stressful. How do you reduce the stress? You turn collections into a routine business process. Coaching our clients on collections has led to a considerable reduction in staff stress, as well as a significant drop in poor accounts receivable. This success incentivizes staff to continue improving.
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How can you use working capital financing in your business?
Working capital is the money made readily available for the day-to-day running of a company. You can use working capital financing for:
- Managing cash flow
- Bridging payment delays
- Purchasing inventory
- Updating equipment
- Paying seasonal expenses
- Covering seasonal shortfalls
- Launching a marketing campaign
- Hiring additional employees
- Expansions or renovations
- Opportunities for growth
- Unexpected expenses
- Outsourcing consulting expertise
- Hardware and software
Successfully growing your business is not an episodic event, but a continuous effort to evolve, advance, and achieve a new level of performance. This growth requires cash, which comes from positive working capital. By understanding the key activities and metrics that support effective working capital management, you can successfully plan for and achieve sustainable growth.
FREQUENTLY ASKED QUESTIONS
Does working capital increase as business grows?
As businesses grow they typically require additional working capital.
How does working capital affect cash flow?
An increase in working capital suggests that more cash is invested in working capital, thus reducing cash flows. Firms with significant working capital requirements will find that their working capital will grow, and this working capital growth will reduce their cash flows.
What types of businesses require lower working capital?
Consulting services or online software providers generally require much lower working capital. Businesses that have matured and are no longer looking to grow rapidly also have a reduced need for working capital.