Working capital determines the extent to which a company is able to meet its short-term financial obligations. Is the company able to continue paying current liabilities such as wages, trade creditors and taxes? The funds for this must be released from current assets. Current assets are funds that can be converted into cash within a year, such as stocks, debtors and cash. Current liabilities are liabilities that must be paid within a year, such as accounts payable and other short-term debts.
The formula for working capital is simple: working capital = current assets - current liabilities
Positive or negative
A positive working capital means that a company has sufficient funds to meet its short-term obligations, while a negative working capital can indicate potential liquidity problems. With a negative working capital, a company is in the danger zone. This is not to say that having the highest possible positive working capital is best. A very high working capital does not necessarily mean that the company is healthy. It could also indicate that the turnover rate of stocks or debtors is too low. This in turn carries very different risks. Think of obsolescence or the risk of debtor losses.
How to manage working capital
Effective working capital management is essential to a company's success. There are some strategies companies can use:
- Stock management: ensure that there is just enough stock (just-in-time) to meet expected delivery obligations. Close cooperation with suppliers and customers is important here. A good inventory control system can take a lot of work off your hands in this respect. The same applies to EDI connections with the systems of the aforementioned parties.
- Accounts receivable management: when establishing the relationship with a new client, try to keep the payment terms as short as possible. It is then important to follow this up properly, where credit management systems like CreditDevice can come in handy. Lower accounts receivable improves working capital and reduces risks of non-payment.
- Credit management: paying creditors a little later improves working capital. Therefore, as with clients, make good payment arrangements with suppliers too.
- Factoring: Most companies doing business with other companies (B2B) usually do not get paid immediately on delivery. The most common payment condition is 30 days and in practice it often gets as much as 1 or 2 weeks later. With factoring, you can ensure that you get most of those receivables (up to 90%) advanced by the factoring company within a few days. By the way, this does not affect your working capital, but allows you to pay suppliers faster and thus negotiate payment discounts. As a result, factoring pays for itself.
Fundamental aspect
Working capital is thus a fundamental aspect of a company's financial health. Through effective working capital management, you can reduce costs and increase profitability. So understanding and managing working capital is essential. Do you have any questions about working capital or how to optimise it for your business? Let us know.
