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What is working capital management?

Working capital management is a business process that helps companies make effective use of their current assets and optimize cash flow. It’s oriented around ensuring short-term financial obligations and expenses can be met, while also contributing towards longer-term business objectives. The goal of working capital management is to maximize operational efficiency.

By improving the way they manage working capital, companies can free up cash that would otherwise be trapped on their balance sheets. As a result, they may be able to reduce the need for external borrowing, fuel growth, fund mergers or acquisitions, or invest in R&D.

Working capital is essential to the health of every business and improving your working capital position can provide a boost to the operational efficiency of a business, but managing it effectively is something of a balancing act.

Companies need to have enough cash available to cover both planned and unexpected costs, while also making the best use of the funds available to fuel growth. This is achieved by the effective management of accounts payable, accounts receivable, inventory, and cash.

Working capital formula

Working capital in financial management is defined as current assets minus current liabilities, meaning it can be calculated simply by subtracting current liabilities from current assets. The working capital formula can therefore be illustrated as:

Working capital = current assets – current liabilities

Current assets include assets such as cash and accounts receivable, and current liabilities include accounts payable.

Other working capital metrics

Other important working capital metrics include:

  • Working capital ratio – a measure of liquidity and another way of looking at current working capital, calculated by dividing total current assets by total current liabilities
  • Days Payables Outstanding (DPO) – the average number of days that the company takes to pay its suppliers.
  • Days Inventory Outstanding (DIO) – the average number of days that the company takes to sell its inventory.
  • Cash Conversion Cycle (CCC) – the average time taken for the company to convert its investment in inventory into cash.

CCC is calculated as follows:

CCC = DIO + DSO – DPO

The shorter a company’s CCC, the sooner it is converting cash into inventory and then back to cash. Companies can reduce their cash conversion cycle in three ways: by asking customers to pay faster (reducing DSO), extending payment terms to suppliers (increasing DPO) or reducing the time that inventory is held (reducing DIO).

Objectives of working capital management

Working capital is an essential metric for businesses to pay attention to, as it represents the amount of capital they have on hand to make payments, cover unexpected costs, and ensure business runs as usual. In other words, it’s a measure of financial health. However, effective management of working capital isn’t simple, and there can be multiple objectives of a working capital management program, including:

  • Meeting obligations. Working capital management should always ensure that the business has enough liquid assets to meet its short-term obligations, often by collecting payment from customers sooner or by extending supplier payment terms. Unexpected costs can also be considered obligations, so these need to be factored into the approach to working capital management, too.
  • Growing the business. With that said, it’s also important to use your short-term assets effectively, whether that means supporting global expansion or investing in R&D. If your company’s assets are tied up in inventory or accounts payable, the business may not be as profitable as it could be. In other words, too cautious an approach to working capital management is suboptimal.
  • Optimizing capital performance. Another working capital management objective is to optimize the efficiency of capital usage – whether by minimizing capital costs or maximizing capital returns. The former can be achieved by reclaiming capital that is currently tied up to reduce the need for borrowing, while the latter involves ensuring the ROI of spare capital outweighs the average cost of financing it.

Effective working capital management

Speeding up the CCC can improve a company’s working capital position, but it may also have other consequences. For example, there is a risk that reducing inventory levels could negatively impact your ability to fulfil orders.

Where DPO is concerned, your accounts payable is also your suppliers’ accounts receivable – so if you pay suppliers later, you may be improving your own working capital at the expense of your suppliers’ working capital. This may have an adverse effect on your relationships with suppliers and could even make it difficult for cash-strapped suppliers to fulfil your orders on time.

Effective working capital management therefore means taking steps to improve the company’s working capital position without triggering adverse consequences elsewhere in your supply chain. This might include reducing DSO by putting in place more efficient invoicing processes, so that customers receive your invoices sooner. Or it might mean adopting an early payment program that enables your suppliers to receive payment sooner than they would otherwise.

Working capital management solutions

Companies can use a wide range of solutions to support effective working capital management, both for themselves and for their suppliers. These include:

  • Electronic invoicing. Electronic invoice submission can help companies achieve working capital benefits. By streamlining the invoicing process, you can reduce the risk of errors, automate manual processes, and make sure that your customers receive your invoices as early as possible – which may ultimately mean you get paid sooner. Electronic invoice submission methods can enable companies to turn purchase orders into invoices automatically or submit high volumes of invoices using system-to-system integration.
  • Inventory management. Smart implementations of inventory management solutions can help to improve your balance sheet position, or your working capital position, by reducing long lead times, ensuring access to safety stock, and making the inventory process more transparent in general.
  • Cash flow forecasting. By forecasting future cash flows – such as payables and receivables – companies can plan for any upcoming cash gaps and make better use of any surpluses. The more accurately you can predict your future cash flows, the better-informed your working capital management decisions will be.
  • Supply chain finance. For buyers, supply chain finance – also known as reverse factoring – is a way of offering suppliers early payment via one or more third-party funders. Suppliers can improve their DSO by getting paid sooner at a low cost of funding – while buyers can preserve their own working capital by paying in line with agreed payment terms.
  • Dynamic discounting. Dynamic discounting is another solution that buyers can use to provide early payment to suppliers – but this time there’s no external funder, as the program is funded by the buyer via early payment discounts. Like supply chain finance, this enables suppliers to reduce their DSO. What’s more, it allows buyers to achieve an attractive risk-free return on their excess cash.
  • Flexible funding. Last but not least, working capital providers that offer flexible funding may allow buyers to move seamlessly between supply chain finance and dynamic discounting models, meaning companies can adapt to their varying working capital needs while continuing to support their suppliers.
Flexible Funding is a feature for Taulia Payables that allows buyer organizations to use the right funding at the right time. It gives corporate treasurers options to meet their short-term cash flow needs without restricting the liquidity suppliers rely on.
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