A company’s working capital is ever-changing — with each month, businesses need enough cash to pay their short-term obligations. But how do you know when to improve your working capital if this number constantly changes?
If your business struggles to collect funds from customers or is scrambling to make bill payments, you need to increase the company’s working capital. You cannot operate with low working capital forever because, eventually, your business will go under due to financial instability.
In this post, we’ll cover everything business owners need to know about working capital, how to improve it, and highlight four red flags that say your company may be in danger.
What is Working Capital?
Working capital is the measurement of cash flow of a business by analyzing the difference between the businesses current cash position, receivables and supply and/or inventory and current liabilities including debt, payables and expenses.
In the context of business liquidity, working capital serves as a critical indicator, reflecting the company's ability to maintain adequate liquidity to meet its short-term obligations while striving to enhance its profitability and operational efficiency. Working capital is essentially the lifeblood of a company and is a key factor in its financial health. When a business states that it "needs" working capital, it implies the requirement for additional capital to finance daily operations and to ensure that the company operates smoothly without liquidity concerns.
How Can a Company Improve Its Working Capital?
Improving working capital is essential for maintaining a healthy cash flow and ensuring a company can meet its short-term obligations. It’s important to manage receivables more efficiently by establishing clear credit policies to determine which customers are eligible for credit and enforcing strict collection processes to ensure timely payments. Offering early payment discounts can incentivize customers to pay sooner, thereby accelerating cash inflows.
Managing payables is equally critical to optimizing working capital.
- Companies should negotiate favorable payment terms with suppliers to delay outflows without compromising relationships or incurring late fees.
- Maintaining a lean inventory can prevent unnecessary capital tie-ups, reduce carrying costs, and minimize the risk of obsolescence.
- Regularly reviewing inventory levels and turnover rates can help businesses adjust to demand fluctuations and maintain an optimal stock level, further bolstering working capital.
If all else fails, applying for a business line of credit or short-term loan can be an effective way to ensure cash flows and have the necessary working capital to sustain business activities.
The Working Capital Formula
You can assess your company’s working capital position with a simple formula. When you divide your assets by liabilities, you generate a working capital ratio reflecting your company’s financial health.
1. Working Capital Ratio
To determine your company’s working capital ratio, take the sum of the business’s current assets and divide it by the sum of current liabilities, like this:
Current Assets / Current Liabilities = Working Capital Ratio
This ratio reveals how stable a company is. If the liabilities are higher than the assets, the business has poor working capital and may have difficulty paying its debts.
Companies should aim for a working capital ratio above 1. A ratio above 1 indicates that the company is stable enough to cover day-to-day production costs. Ideally, your ratio is between 1.5 and 2. When you’re within this range, your company is on solid financial ground and has the liquidity to handle unforeseen expenses.
2. Net Working Capital Formula
If you want to calculate your company’s current cash on hand, you can use a formula to find the net working capital (NWC). The NWC formula uses the same inputs but is slightly different:
Current Assets – Current Liabilities = Net Working Capital
Net working capital helps companies understand how much cash they have at their immediate disposal to cover short-term obligations. This number should never be negative — a business can’t pay its bills with a negative balance!
Using these formulas reveals how stable your business is in the short term and lets you know when you should take measures to bolster your working capital position.
3. Explanation of Assets Vs. Liabilities
Now that we’ve covered the math, let’s look at business assets and liabilities. Here’s a more detailed breakdown of what should fall into each category when you estimate assets and liabilities. On the assets side, knowing your inventory turnover ratio is critical, as it indicates how efficiently inventory is managed and plays a significant role in your working capital levels.
The following information is considered a company asset:
- Cash and investments, including cash equivalents which are vital for meeting short-term obligations
- Inventory stock, with a high inventory turnover ratio reflecting strong sales and inventory management
- Accounts receivable
- Prepaid business expenses
On the other hand, company liabilities are:
- Employee salaries (Payroll)
- Accounts payable
- Taxes
- Loans and debt
- Operational bills (utility, rent, etc.)
- Prepaid services (in case your company cannot complete the work and needs to return the customer’s funds)
When calculating working capital, remember to include cash equivalents as part of your current assets. You’ll need to find the sum of all the assets, including cash equivalents, and all the liabilities. Ensure everything in the business is accounted for to estimate your working capital position accurately.
Why Working Capital Is Important
Good working capital management is essential to create a well-functioning business — it provides a cushion for necessary and unexpected expenses.
As a business owner, you know that unexpected expenses can pop up from time to time. These expenses can range from small repair projects to high-cost issues. Here are some unexpected problems that can arise throughout a company’s lifetime:
- Broken equipment (computers, vehicles, heavy machinery)
- Unplanned shutdowns or inventory shortages
- Product recalls
- Increase in rent or utility bills
- Repairs for office issues (out-of-order bathrooms, elevators, etc.)
These are just small examples of what can harm day-to-day operations within your company. Without enough working capital, any of these problems will create serious financial issues — leaving you unable to pay for essential bills and other business expenses.
4 Reasons for Working Capital
Collecting all the information to calculate your current working capital ratio can be time-consuming — but it’s a crucial step that accounts for every possible asset and liability in your company.
But once you’ve gathered your data and calculated your ratio, how do you know whether or not your company needs to increase your working capital? Take a look at these four red flags that could indicate your business has low working capital.
Reason #1: You’re Experiencing Negative Cash Flow
Your company will have a negative cash flow when your current liabilities weigh more on the business than the existing business assets. Heavier liabilities than assets are incredibly problematic and can hinder business opportunities. Extended periods of negative cash flow will result in company closure, putting you and your employees out of work.
If your company buys products to sell to consumers, it’s vital to have efficient inventory management to ensure you don’t have cash flow issues. An overflow of inventory can exacerbate your negative cash flow if the product does not sell: After all, you paid for these goods but aren’t making money off them.
When you’re in a cash flow crunch, you’ve got a few options to keep your business afloat, like renegotiating payment terms for debt and applying for small business loans.
Additionally, companies can offer exclusive sales and discounts to increase product sales. If your company decides to use discounts to drive sales, be sure you’re still making enough profit from each transaction.
If you find that your company’s finances are in the red, it’s essential to work on improving your working capital management (which we’ll cover below). The goal should be to end each month with positive net working capital!
Reason #2: Your Business Is Financing Fixed Assets
Fixed assets are items of value the business owns, such as operations buildings, company vehicles, land, and equipment. These assets will come in handy if your business encounters a rough financial patch because you can sell them off to cover expenses.
However, a big problem can occur if most of your fixed assets are financed. When you finance fixed assets, the business puts its buildings, vehicles, or other items up as collateral in exchange for a loan. That means if you cannot repay the loan, the lender can come in and seize your fixed assets.
This is not a good position to be in when you want to increase your company’s working capital. Financing fixed assets signify that a business is struggling to boost cash flow. The bottom line is it’s incredibly risky, and one wrong move can signal the end of a company.
Reason #3: Customers Aren’t Paying in a Timely Fashion
Companies should require customers to pay for goods and services at delivery time to generate the most cash flow. This practice ensures your business receives the funds it needs to continue operating smoothly and avoids short-term debt, which is critical for maintaining a healthy working capital. Paying attention to the state of your invoices can help resolve disputes with customers and prevent sales invoices from becoming stagnant.
Allowing customers to pay after delivery is good for client relationships, but it’s not beneficial for working capital management. Sure, you can tack on additional fees for late payments, but your company finances could go negative if you’re waiting for several clients to pay their debts all at once. Streamlining A/R processes and unlocking access to cash tied up in unpaid invoices might be imperative to sustain your business's financial health.
Reason #4: Your Products or Services Are Vulnerable to Market Fluctuations
The value of goods and services will always ebb and flow. But because of this uncertainty, purchasing a high volume of inventory is dangerous — you have no way of knowing if these goods will sell or sit on the shelves.
The longer a product takes to sell, the more likely its value will depreciate. For perishable items, the supply could spoil before the inventory stock is depleted.
In addition, companies can suffer when a newer, more efficient model enters the market. You’ll be forced to sell the older products at a discounted rate and might not recoup your initial investment, which means your working capital ratio will decrease.
The going rate for providing services can fluctuate as well. For instance, imagine you run a construction company and opening a new construction business within your service area. You’ll be forced to compete with this other business — and if they offer services at a cheaper rate, you could lose valuable customers.
By creating a working capital improvement plan, you create a financial buffer that helps your business cope with market fluctuations.
Things to Remember When Increasing Working Capital
Without enough working capital, companies can be put out of business — even if the demand for goods and services is high. This happens when a business does not have enough cash on hand to cover its company liabilities.
Think of it this way: If you can’t pay the electric bill, your staff can’t work.
When you’re working on boosting your company’s working capital, you’ll need to anticipate situations that can significantly impact your financial stability. Here are three things your business can do to strengthen its financial position.
Tip #1: Always Expect the Unexpected
In early 2020, companies across the country were forced to close their doors to in-person consumers due to the rapid spread of the Covid-19 virus. Some businesses had no means to deliver their products and services, which resulted in permanent closures.
The business world had no idea that a contagious virus would severely affect their operating ability. Good working capital or not, many companies went under during the stay-at-home order.
The more businesses closed, the harder it became for existing companies to operate. For example, owners who relied on manufacturers for product delivery were left with nothing to sell to consumers.
That’s why, as a business owner, you should always expect the unexpected. There is always a possibility of unforeseen shutdowns or product shortages when simultaneously trying to improve working capital.
While you can’t predict the future, you’ll be able to handle any potential issues if your company is financially well-prepared.
Tip #2: Monitor Accounting and Inventory Stock
Retail businesses must account for potential theft and unsellable items to maintain a good working capital ratio. If you frequently encounter customers with sticky fingers, you’ll need to improve security measures to prevent excessive losses.
Managers should place high-cost items within a locked case where employees can retrieve the product before purchase. Additionally, areas with expensive products should be monitored by employees to avoid any potential accidents or broken merchandise.
Another concern is inner-departmental theft. No business owner wants to suspect that someone would steal from their company, but unfortunately, employee theft can happen. This type of theft can be detrimental to your company’s financial health, especially if stealing goes unnoticed for a long time.
Always stay vigilant and attentive to accounts payable, receivable, and inventory numbers. If money and items are frequently missing without explanation, you need to investigate with extra security measures like logging names and installing cameras to figure out what’s happening. Regular audits and keeping a close eye on your inventory turnover ratio can alert you to discrepancies that may indicate theft or other issues affecting inventory levels.
Tip #3: Consider Medical Emergencies and Extended Time Off
When you think about your business, are there any outstanding employees you consider essential to your day-to-day operations? You might want to rethink your business model if the answer is yes.
No one can predict when an employee will need extended time off for family emergencies, medical issues, or other crises. If the company cannot function for a length of time without this individual, your production and customer satisfaction can decrease significantly in their absence.
This issue can be incredibly problematic for small business owners, so you should always be prepared ahead of time to avoid taking a hit on your working capital. It's crucial to manage your human resources effectively to maintain business liquidity, with strategies that may include cross-training employees, which not only ensures operational efficiency but also prepares your company for unexpected staff absences.
Having part-time or contracted employees is another proactive measure that can help ensure you have enough coverage and preserve liquidity in the event of a vital yet absent employee.
Conclusion
Managing a company’s working capital can sometimes feel like a tightrope because assets and liabilities will consistently fluctuate, making maintaining a good working capital ratio feel impossible.
If you want to increase your working capital, remember these essential tips:
- Avoid financing the company’s fixed assets because of frequent negative cash flow. At first glance, this looks like a method to raise working capital, but it can quickly backfire if you can’t repay your loan.
- Customers should pay for products and services immediately upon delivery. Allowing customers to pay later can seriously impact working capital. If the business doesn’t get its funds on time, it can’t pay its debts.
- Be careful when purchasing large amounts of high-risk products. If you have too much inventory, items can become outdated and obsolete before the business can sell them.
With two decades of experience transforming small businesses into success stories, AdvancePoint Capital specializes in helping businesses increase their financial stability. Contact us today to learn more about our services and request a free consultation.
