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The Importance of
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Managing your working capital requires good balancing skills: if your working capital ratio (also known as current ratio) is less than 1 than you have negative working capital and your business will be challenged to cover your short term or immediate liabilities.
If your working capital ratio is high (high is considered to be over 2) that can mean that your inventory is high (not a good thing) or that you have excess cash (not usually a small business owner's problem) that you should be re-investing into the business. Ideally (but this is dependent on the type of business you own and operate), your working capital would be in the range of 1.2 to 2.0.
Working Capital Formula:
Working Capital Ratio is Current Assets divided by Current Liabilities.
For example, if your business has current assets of $80,000 (for example, cash, receivables and inventory) and current liabilities of $68,000 (for example, salaries and benefits, payables (for materials or services or other bills), debt (both short term and current debt), and more) then your current ratio would be 1.18 which is considered reasonably good.
Make sure that you understand all your financial ratios and the impact on your business.
Working capital is also known as net working capital. Working capital management, just like cash flow management, typically focuses on the short term (one year) or near term (this month, this quarter).
Your Working Capital Policy:
Working capital management must focus on:
Maintaining reasonable and regularly-turning inventories (if inventories are too high, it is difficult to liquidate them if needed and you may be forced to write-down the value of the inventory; if inventories are too low, you may be losing sales which will negatively affect receivables);
Collecting receivables in a timely fashion and not allowing receivables to extend over long periods of time. Ensure that your customers understand your payment terms and that you follow up with them when they don’t pay on time.
If you have customers that continually stretch their payments out over 60 days, you may need to have them put a deposit on purchase up front, or pay up the whole amount up front or cash on delivery (COD), or pay in stages. If you don't manage your receivables well, it can have a detrimental effect on your cash flow and working capital.
Understanding clearly your day-to-day cash needs; you need to know what your expenses will be and whether or not you have the funds to cover those expenses.
If your short-term cash inflows are less than your cash outflows, you will need to make difficult cash management decisions such as increasing your line of credit (or obtaining working capital financing some other way – shareholder’s loans, new investors, largest supplier lines of credit, and more), selling off inventory, laying off staff, looking for more cost-effective supplies and suppliers, requiring poor paying clients to pay at time of ordering (you cannot afford to 'finance' them), and a number of other options.
One of my clients had more than 25% of his clients in the over 90 days overdue column on his receivables. In trying to collect these overdue bills, one of those clients would tell him that he would pay his bill when he got paid.
We worked hard to clean up his receivables – one of the more successful solutions was hiring a part time, retired collections clerk. She was very pleasant, very persistent (wouldn't take no for an answer) and by tracking customers with a bad paying history, she would catch them before they went into the overdue column.
Most business owners work hard and focus on getting startup financing; then, once the business is up and running, they focus on their small business plan, their human resources, their products and/or services and small business sales. They hope that the financials will take care of themselves if the business grows.
Don't fall into that trap, work with your accountant to build a strong financial program. If you don't have an accountant, consider the advantages of outsourcing: you can look for part-time (or even one-time) specialists in finance and accounting to help you set up your bookkeeping, your corporate taxation, and focus on working capital management.
Most small business owners would prefer to calculate profits rather than focus on working capital management. But, rather obviously, you need to be successful at managing your working capital policy and your cash flows or you won't be in business for long. Build your business by focusing on, and managing, your working capital formula in day-to-day activities and in your business financial plan.
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Additional Reading:
Business Sale Agreement: Use Business Valuation Tools Before Selling
Business Valuation Methods: Use a Small Business Valuation Formula
Profit Maximization and Cash Flow Management
Gross Profit Margin: Understanding It Will Help You Better Manage Your Business
Return From Working Capital Management to How to Calculate Profit
Or Return From Working Capital Management to More for Small Business Home Page