Posted in Business basics | by: David Clayton

Working Capital: What Is It and Why Should I Care About It?

Imagine you’re a toymaker. Someone on your sales team hangs up the phone and walks excitedly toward your office with big news: they just closed the biggest order that your company has ever received. They’re ecstatic, but your mind is elsewhere: here is the big opportunity you’ve craved, but how will you make it happen? There’s not enough inventory to meet the order. You can buy more today, but you don’t have enough cash in the bank to pay for it all. Some of your customers haven’t even paid their invoices yet, and you cross your fingers and hope they’ll pay you soon. You quickly realize that working capital is the one thing that will determine whether or not this order becomes your big break.

So what is it exactly? Working capital is the funding that your business needs to operate on a daily basis. As a toy manufacturer, you need cash for day-to-day expenses: that is working capital. You need inventory: that is working capital. And the invoices that your customers pay 30 to 90 days later: the money trapped in them is working capital, too.

Why does it matter?

Without working capital, your company grinds to a halt. Imagine owning the toy manufacturing plant and discovering you had no parts on your shelf to put into your machines. Or imagine you had to meet payroll and realized you had no cash in the bank. The less working capital you have, the greater risk you run of having a cash flow crunch in which you struggle to buy new inventory or pay a bill.

But too much working capital can hurt a company’s finances, too. If an electronics manufacturer builds up too much inventory and it sits on a shelf long enough to become obsolete, then the company must write off the value of the inventory it can’t sell.

Working capital management involves finding the right place between “too much” and “too little,” and then managing it accordingly.

What is the relationship between working capital and cash flow?

Earlier we defined working capital as the funding needed to operate on a daily basis, including cash. Working capital can also be thought of as “cash and things that will soon turn into cash.”

This is important because at the end of the day, cash is what your business needs to meet payroll, buy more inventory, or pay expenses. Our toy manufacturer’s employees probably don’t want to be paid in toys – even if their kids would be very happy with that arrangement.

This means that within the category of working capital, different kinds of working capital are more or less immediately useful:

  • Cash can be used to meet expenses today.
  • Accounts receivable can’t be used to immediately meet expenses, but by using accounts receivable financing they can be converted quickly and easily to cash to meet those expenses.
  • Inventory can’t be used to meet immediate expenses, but if necessary you could have a sale to raise the cash you need to meet those expenses.

Good working capital management pays attention to the mix of working capital types, not just the total amount.

How to improve working capital?

Here are three foolproof ways to improve your working capital situation:

Reduce your accounts receivable. Businesses – particularly small ones who serve big clients – can find themselves waiting 30, 60, or even 90 days to be paid by their customers. If you have $40,000 in accounts receivable and clients pay you after 60 days on average, reducing this to a 30-day term will add $20,000 to your bank account!

Pro tip: if you don’t have negotiating power, offer an incentive. “2/10” terms are common, where a customer gets a two percent discount if they pay an invoice within 10 days instead of the normal 30-90 day period.

Watch your inventory. Back-of-the-envelope forecasting by smaller businesses can result in more inventory than necessary. Hey, if you saw a $100 bill on your shelf, wouldn’t you want to pick it up and use it? A $100 toy in your inventory is the same thing: reduce your inventory by that $100 toy and you have just added more cash to your bank account.

Pro tip: If you have multiple products, look at each one separately instead of looking at your total inventory. Some items may be unpredictable sellers, and you need more inventory in case of a spike in sales. Others may be very predictable sellers and you can hold less “just-in-case” inventory.

Get access to working capital financing. You can’t always control when your customers pay or when expenses are due, but you can fully control your credit line. Having working capital financing available will free you up to focus on growing your business without worrying about every big change in inventory or cash.

Pro tip: Get a credit line in place before you need it. This way you have time to find the best small business funding and a good financing partner so you won’t have to make a fast, suboptimal decision during a crisis.

Working capital can be complex. By following these quick steps, however, you can increase the quality of your working capital and make sure that a sudden cash crunch won’t bring your business down.

 

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About David Clayton

David Clayton writes about small business finance for BlueVine, an invoice factoring company. David enjoys building his understanding of small business by listening directly to the stories of small business owners, a skill he honed while previously doing consumer research in Latin America. You can get in touch with David here.