What is working capital management?

Let’s say you run an e-commerce site selling homemade jewelry. After a year of strong demand, you decide you’d like to establish a retail presence by opening a kiosk at your local mall. How do you know if the business can afford to do this?

Situations like these are one of the reasons businesses track working capital. Working capital management is a proactive approach to maintaining a view into a business’s current assets and liabilities so that the company can have maximum operational efficiency.

In this guide, we’ll break down everything business owners, CFOs, and accountants need to know about working capital and working capital management so that they can put their business in the best position for success.

‍What is working capital?

Working capital (also known as “net working capital”) is a financial metric that represents the difference between a company’s current assets (i.e., economic benefits the business expects to receive within 12 months) and its current liabilities (i.e., debts a company owes or will owe within the next 12 months). It is a reliable indicator of a business’s financial health. 

So if, for example, our aforementioned homemade jewelry business had $50k in assets and only $20k in liabilities, its working capital would be $30k. Positive working capital means the business has enough money on hand to pay its bills and potentially invest in growth initiatives. 

Pouring over the details of your financial statements and tracking working capital ensures the business has enough cash on hand to meet short-term obligations, such as employee wages, tax payments, and utilities, as well as cash to fuel growth initiatives.

Components of working capital

Working capital is comprised of a business’s current assets and current liabilities, all of which should be reflected on the business’s balance sheet. Let’s break down each component in greater detail:

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Note that, depending on the business, not all of the above components of working capital will be reflected on the balance sheet. A service company, for example, will likely not have inventory to factor into their working capital calculations.

Types of working capital

Aside from working capital’s components, there are a handful of different “buckets” of working capital business owners should be aware of, as each serves its own business function. They are as follows:

• Permanent working capital: Also known as fixed working capital, permanent working capital refers to the minimum amount of capital needed to cover current liabilities.
• Regular working capital: Current assets recognized and the current liabilities incurred. Regular working capital represents the minimum working capital required for “normal” operations (e.g., payroll, materials, overhead, etc.).
• Reserve working capital: Working capital reserved for unusual circumstances or unforeseen expenditures (i.e., savings). 
• Fluctuating working capital: Capital invested in the business for a temporary period of time. This can be seasonal working capital (i.e., additional working capital needs during peak business season) or special variable working capital (i.e., a rise in working capital due to an unforeseen event). Fluctuating working capital can be determined by subtracting permanent working capital from net working capital. 
• Gross working capital: Highly liquid assets that can easily be converted to cash in short order.

How to calculate working capital

The working capital formula is simple: 

Working capital = current assets - current liabilities

As an example, let’s consider the following balance sheet:

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To calculate working capital, we’d simply subtract $19,500 from $37,500.

$37,500 - $19,500 = $18,000 in working capital.

Positive vs. negative working capital

The above calculation is an example of positive working capital. That is, a business that has more current assets than it does current liabilities. When a business has positive working capital, there’s less of a risk that it will be unable to pay its debts.

‍The opposite of positive working capital, of course, is negative working capital. If a business’s current liabilities exceed its current assets, it’s said to have negative working capital. Negative working capital means the business would likely struggle to pay off all its debts if it had to do so in short order. Negative working capital is also a red flag to vendors and lenders, as it signals the business would not be a reliable partner given its capital constraints.

‍Of course, the amount of working capital a business possesses at any given time will ebb and flow based on business performance. To ensure the business never has negative working capital, careful working capital management is required.

What is working capital management?

Working capital management is a set of tasks associated with analyzing and optimizing the relationship between current assets and current liabilities. 

‍Good working capital management ensures the business has enough financial resources on hand to sustain and / or scale operations and maximize your chances of profitability. 

‍The task of working capital management is typically the responsibility of a business’s finance team. 

‍To effectively manage a company’s working capital, an accountant or CFO will track the ratio of current assets to current liabilities, forecast future cash inflows and outflows, and assess current accounts receivables and accounts payable, inventory, short-term debt, and spending patterns.

‍The finance team will then report to leadership on the current status of the business’s working capital, enabling leadership to make informed business decisions. 

Why should companies invest in working capital management?

Effective working capital management provides a business with numerous benefits:

1. Maintenance of liquidity: Ensures the business has enough cash on hand to cover operating expenses.
2. Facilitates investment decisions: Helps business leadership determine if and how much they can afford to invest in business growth, like opening a new store. 
3. Smoothes revenue fluctuations: Identifies opportunities to smooth out fluctuations in revenue.
4. Optimizes capital costs: Can lower capital costs and increase capital returns.
5. Covers seasonal downturns: Can help you prepare for black swan events or seasonality-related shocks. 
6. Funds short-term investments: Ensures access to cash for immediate or upcoming project needs.
7. Optimizes procurement: Allows businesses to set up adaptable payment terms and unlock potential pricing discounts from supply chain providers.
8. Reduce reliance on short-term financing: Effective cash flow management minimizes dependence on loans to cover short-term expenses. 

Components of working capital management

The process of working capital management can be further broken down into a handful of related activities:

• Liquidity management: Ensuring the company has enough readily available cash to meet its day-to-day business needs.
• Accounts receivable management: Ensuring cash owed to the business by debtors is received in a timely fashion.
• Accounts payable management: Ensuring cash owed by the business to its vendors and suppliers is paid in a timely fashion so as to avoid late payment penalties and fines.
• Short-term debt management: Ensuring the business has enough liquid assets to handle short-term debt obligations and / or acquire financing.‍
• Inventory management: Ensuring inventory levels are high enough such that the business can fulfill customer orders while also not being so high as to be an inefficient use of working capital and maximize your cash conversion cycle.

Working capital management ratios you need to know

To execute the balancing act that is working capital management, finance teams rely on a handful of different metrics, which we’ll detail below.

Quick ratio

The quick ratio measures a business’s current assets that can be easily converted to cash. The formula is as follows:

Quick ratio = (current assets – inventory) / current liabilities

You use the quick ratio to understand which assets can be quickly converted to cash in instances where you need to increase a company’s liquidity. 

Current ratio

The current ratio is the working capital formula expressed as a ratio. The formula is as follows:

Current ratio = current assets / current liabilities

Every business wants a working capital ratio of greater than 1, as this indicates the business has enough capital to cover its obligations. To go back to our balance sheet example, a business with current assets of $37.5k and current liabilities of $19.5k would have a current ratio of roughly 1.92. This means that for every dollar the business owes, it has $1.92 to spend.

Days payable outstanding (DPO)

DPO measures the average number of days it takes a company to fulfill its accounts payable. The formula is as follows:

Days payable outstanding = (average accounts payable / cost of goods sold) x number of days in accounting period

DPO provides insight into how good an organization is at managing its accounts payable. There’s no “right” DPO to aim for, per se. DPO often fluctuates based on the industry the business operates in, its bargaining power, and its competitive positioning. 

Having a high DPO can actually be advantageous for a company, as it offers the business greater capital flexibility. At the same time, failing to pay creditors in a timely fashion can result in penalties and fees. A high DPO can also be a reflection of the business’s inability to pay creditors on time.

A low DPO, on the other hand, may indicate the business isn’t fully leveraging the credit period offered by creditors. It could also mean the business has bad credit terms, requiring it to pay back creditors quickly. 

Average collection period

The average collection period measures the amount of time it takes a business to have its accounts receivable fulfilled. The formula is as follows:

Average Collection Period = 365 Days x (Average Accounts Receivables / Net Credit Sales)

The average collection period informs a business if it has enough cash on hand to meet its financial obligations. The average collection period is also a reflection of a business’s accounts receivable management practices. 

The lower the average collection period, the faster the business receives payment, which is typically beneficial to the business (e.g., it can pay its suppliers and other short-term obligations more quickly).

AP turnover ratio

The accounts payable turnover ratio measures the rate at which a company pays off its suppliers. The formula is as follows:

AP turnover ratio = TSP / ((BAP + EAP)/2)

In this equation, TSP stands for “total supply purchases,” BAP denotes the beginning of the accounts payable period, and EAP stands for the end of the accounts payable period. 

The AP turnover ratio reveals how many times a company pays its accounts payable within a given time period. It’s another useful metric for determining if the company has enough cash on hand to meet its short-term obligations. A high AP turnover ratio indicates the company is meeting vendor payment obligations.

AR turnover ratio

The AR turnover ratio measures the amount of times a company collects its average accounts receivables balance within a given time period. The formula is as follows:

AR turnover ratio = Net credit sales / average accounts receivable

The AR turnover ratio is a reflection of how good a company is at collecting outstanding balances from clients. An efficient company has a high AR turnover ratio. It can be informative to compare a business’s AR turnover ratio with other businesses in the industry to understand if the business’s credit processes are competitive. 

Inventory turnover ratio

Lastly, inventory turnover ratio reveals how many times a company has sold or replaced inventory relative to COGS within a measured time period. The formula is as follows:

Inventory turnover = COGS / average value of inventory

Generally, a business wants to have a high inventory turnover ratio, as this indicates the company moves a lot of inventory (i.e., makes sales). The faster the company sells its inventory, the lower overhead cost for storage or risk of obsolescence. Inventory turnover ratio is another metric that’s compared across businesses in the same sector to understand how competitive the businesses inventory management processes are.

7 ways to increase working capital

Businesses can increase working capital by cutting down on their short-term debt obligations or acquiring more capital via financing. Here are some specific tactics businesses employ to increase working capital:

1. ‍Take out a long-term loan: Long-term debt increases a company’s current assets while not adding significantly to its current liabilities. ‍
2. Refinance short-term debt: Converting short-term debt into long-term debt reduces the business’s current liabilities.‍
3. Sell illiquid assets: Converting illiquid assets into cash increases current assets.
4. ‍Optimize spend: Analyze where the business currently spends money with an eye to cut some of these expenses, or seek out cheaper suppliers. Reducing spend will reduce current liabilities.‍
5. Optimize operating cycle: Ensuring the business only maintains just as much inventory as it needs can reduce current liabilities.‍
6. Automate accounts receivable: Improving your collection ratio by streamlining the AR process (e.g., via an online portal) can increase a company’s cash flow.‍
7. Credit check new customers: Only taking on customers with high creditworthiness can reduce AR cycles.‍
8. Offer early payment discounts: Incentivizing customers to pay quickly can also reduce AR cycles and increase current assets.

Wrap-up: Optimize working capital with Rho

Management of working capital is important—but it doesn’t need to be difficult. 

‍The Rho platform’s budgeting, AP automation, corporate card spend controls, and more can help businesses make working capital management a cinch, including automated accounts payable, banking services, expense management and more. 

‍To learn more about how Rho can optimize your business’s working capital and financial management, get in touch. 

‍Matthew Speiser is a finance content writer who specializes on topics including startups, venture capital, corporate finance, and business banking.