This article is for informational purposes only and does not constitute legal, accounting, or tax advice. For specific advice applicable to your business, please contact a professional.
Understanding working capital is key to managing your business’ cash flow and making significant purchases to help your business grow. Having a healthy working capital ratio also provides a financial buffer for when things don’t go as planned. Here we outline what working capital means and how to manage it for business success.
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What does working capital mean?
Working capital is defined as the difference between your current assets and liabilities, usually within the timeframe of 12 months. It’s the leftover available money you have once you are current on all your accounts and when all money owing to you is paid. This is the money that’s used to operate your business day-to-day, from paying subscriptions to purchasing supplies.
But as well as cash, operating working capital includes assets that can be quickly converted to cash. These types of capital are:
- Cash. This is the cash in the business’ bank account that’s available immediately and used to pay invoices, wages and supplies (also known as cash payable).
- Accounts receivable. These are payments you are waiting on from your customers, which may take 7 days to 90 days depending on your invoice terms. These payments are cash once they’ve hit your account (also known as cash receivable).
- Inventory. This is your stock on hand. Inventory is deemed working capital because if you need cash, it can be sold at a discount to raise cash quickly.
How to calculate your working capital
You can easily calculate your working capital using the following equation:
Current assets – current liabilities = working capital
‘Current assets’ are listed in the types of working capital above, and ‘current liabilities’ means the costs you owe soon – think short-term debt payments from a small business loan and accounts payable (eg. a bill).
If your business has more current assets than current liabilities, you are working capital positive and your business has enough working capital to keep operating. A healthy working capital ratio is somewhere between 1:1 and 1:2, where 1:1 would mean you’re just able to meet short term payments and 1:2 may mean you’ve got more cash in your bank account that necessary – the excess may be better invested in increasing marketing spend or bringing on another employee.
Working capital management tips
Tightening up your cash flow and keeping a close eye on your inventory are the best ways to increase your operating capital. Cash flow measures the ability to generate cash over a specific period, whereas working capital is a snapshot of a present situation. Improving your cash flow will mean you’re well placed in any given moment to have the cash on hand needed to cover hefty expenses, planned or not.
There are three key tactics to increase your working capital:
1. Stay on top of your cash receivables
Communicating with your customers about how you expect to be paid, and what will happen if they pay late, is the first step to improve your likelihood of being paid on time.
- Setting your invoice terms. Use benchmarks in your industry to determine what’s a reasonable payment window – 30 days is often standard. You may find you’re more likely to be paid by allowing payment installments over time.
- Manage invoicing and billing. The sooner you can create and send an invoice, the sooner you can be paid. Create a system that alerts you when due payments are coming up. Investing in robust accounting software, like Xero, will enable you to set up your system seamlessly.
- Collection policy. What happens if someone pays late? A collection policy might look like a surcharge or a fee to incentivise late payments.
2. Slow down your cash payables
Take advantage of credit and payment terms so you can hold as much cash as possible in your account at any time.
- Apply for credit. Ask your suppliers for the latest possible terms they offer. Set reminders for when your payments are due – ensure you always pay your bills on time to keep your credit score high and in turn increase the likelihood of establishing late payment terms from other suppliers in the future!
- Create a cash flow forecast. A cash flow forecast will tell you what’s due when, usually monthly over the timeframe of a year. This allows you to make decisions about when you’re best placed to make larger payments, for instance in your high seasons. Here’s a cashflow forecast template you can use.
3. Manage your inventory
Inventory ties up significant cash for many businesses, so it’s essential to have enough inventory to meet customer demand without having too much stock sitting on shelves (meaning you can’t spend on other things).
- Create a sales forecast. How much do you expect to sell this year? Like the cash flow forecast, create approximate sales targets for each month, taking into account seasonal fluctuations, so you know how much stock to keep on hand to service your market.
- Track your inventory as closely as possible. If you work with a warehouse you may get stock reports daily, which are updated as products are sold. Barcoding your products creates a tight system to track your stock. In-person stock-takes to double-check the data before making reorders or preparing for the end of the financial year is also a way to stay close to your inventory.
- Monitor your deliveries. Often suppliers ship late or include incorrect products in deliveries. You can negotiate payment reductions based on any delayed or incorrect shipments to decrease your cash payable and improve stock control.
Consider working capital loans
If your operational working capital is slim, it could be worth looking into small business loans such as Square Loans to help you manage your cash flow and position your business to prepare for growth. Some businesses have significant inventory payments (due to high minimum orders), long production lead times (if they have overseas suppliers) or fluctuating sales seasons (resulting in payment delays).
Loans are useful to increase working capital at vital times, like in the lead up to busy periods to maximise sales potential. Loans can then be repaid once payments from sales are realised.
Understanding your own business’ working capital finance may take a bit of work to figure out, but when you do you’ll be better placed to manage and grow your business – and be more financially ready for unexpected events!