Working Capital Basics and Best Practices

Working capital — the funds your company has tied up in accounts receivable, accounts payable, and inventory — is a critical performance metric. During times of rising inflation and interest rates, managers search for ways to free up cash and eliminate waste. However, determining the optimal amount of working capital can sometimes be challenging.

How Much Working Capital Do You Need?

The amount of working capital your company needs depends on the costs of your sales cycle, upcoming operating expenses, and current repayments of debts. You need enough to finance the gap between payments to suppliers and creditors (cash outflows) and customer payments (cash inflows).

Too much working capital on the balance sheet can drain cash reserves, requiring a company to tap into credit lines to make ends meet. In addition, money tied up in working capital can detract from growth opportunities and other spending options, such as expanding to new markets, buying equipment, hiring additional workers, and paying down debt.

But having too little working capital to act as a buffer can also create problems — as many companies learned from supply chain shortages during the pandemic. Ongoing geopolitical uncertainty has caused some companies to scale back on just-in-time inventory practices, causing working capital balances to increase.

The Goals of Working Capital Management

There are three main goals for managing it:

  1. To ensure the company has enough cash to cover expenses and debt.
  2. To minimize the cost of money spent on funding working capital.
  3. To maximize investors’ returns on assets and investments.

Maintaining a positive working capital balance requires identifying activity patterns related to line items within the current asset and liability sections.

Management Strategies

Working capital best practices vary from industry to industry. Here are three effective ways to manage working capital more efficiently:

Expedite Collections

Possible solutions for converting accounts receivable into cash include tighter credit policies, early bird discounts, collection-based sales compensation, and in-house collection personnel. Companies can also evaluate administrative processes — including invoice preparation, dispute resolution, and deposits — to eliminate inefficiencies in the collection cycle.

Trim Inventory

This account carries many hidden costs, including storage, obsolescence, insurance, and security. Consider using computerized inventory systems to help predict demand, enable data-sharing up and down the supply chain, and more quickly reveal variability from theft.

It’s important to note that, in an inflationary economy, rising product and raw material prices may bloat inventory balances. Higher labor and energy costs can affect the value of work-in-progress and finished goods inventories for companies that build or manufacture goods for sale. So, rising inventory might not necessarily equate to having more units on hand.

Postpone Payables

By deferring vendor payments, your company can increase cash on hand when possible. But be careful: Delaying payments for too long can compromise a firm’s credit standing or result in forgone early bird discounts. Many companies have already pushed their suppliers to extend their payment terms, so there may be limits on using this strategy further.

Some organizations are so focused on the income statement, including revenue and profits, that they lose sight of the strategic significance of the balance sheet — especially working capital accounts. We can benchmark your organization’s liquidity and asset efficiency over time and against competitors. If necessary, we also can help implement strategies to improve your performance without exposing you to unnecessary risk. Contact us today!

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