Financial Explainer — working capital

As a small business owner, it's crucial you understand how your finances work. This is one of the starting points to a successful business.

Your working capital, i.e. the difference between your current assets and current liabilities.

Here's why it's important:

Liquidity indicator: Your working capital shows the extent to which you can cover your short-term liabilities with your short-term assets.
Operational efficiency: It shows how well you're managing your inventory (stock), your accounts receivable (how much you're owed) and your accounts payable (how much you owe).
Financial health: Generally, positive working capital is a sign of good financial health while negative working capital points to potential liquidity problems.

But the key to success is to get the balance right.

You should aim to have enough working capital for your operations to run smoothly but not so much that you have under-utilised assets.

Let's look at that more closely.

Excessive positive working capital should be avoided

This is because it suggests an issue with one or more of the following:

Too much inventory: This is best avoided because it ties up cash that can be used elsewhere. Storage costs also need to be factored in along with the risk of obsolescence.
High accounts receivable: Are your receivables rising as a percentage of sales? This could indicate that your credit policies are too lenient or your collection process is ineffective. There is also the risk of bad debts if customers take too long to pay.
Too much cash: This is when you have idle cash that generates little or no return. Or is not being used to pay down debt. Either is inefficient.
Lack of focused operational efficiency: Excess working capital can be a sign that managers are less vigilant about cost controls and process improvements.

Negative working capital is not always a bad thing

Here's why:

High inventory turnover: Some industries, such as supermarkets or fast food chains, sell their products and replenish them quickly. This reduces the need for large inventories. Service companies also tend to have low or negligible inventories.
Favourable supplier credit terms: As we mentioned in our last finance issue, negotiating longer payment terms with your suppliers (in your trade payables) can act as 'free money' — providing you with less need to rely on external financing.
Some seasonal businesses: Companies, such as tour operators, take large customer deposits early on (recorded as deferred revenues). Their trade payables are then also large because they don't need to pay their suppliers (hotels and airlines) for months. This negative working capital later reverses as services are delivered (people take their holidays) and suppliers are paid.

Your working capital should be managed efficiently

Here are some strategies you could try:

Monitor your cash flow: By creating rolling cash flow forecasts, you should be able to anticipate your future needs and adjust accordingly.
Optimise your inventory levels: Use just-in-time (JIT) inventory management, flexible ordering practices and/or inventory ratios to reduce your excess stock and identify slow-moving items.
Improve your receivables collection: Set clear credit policies and terms. Use efficient invoicing and follow-up procedures. And consider discounts for early payments.
Negotiate favourable payment terms: Longer payment cycles will delay cash outflows.
Use working capital ratios: We discuss working capital ratios in this blog.
Implement cost control measures: If you regularly review and control your expenses, this can help eliminate inefficiencies, improve profitability and free up cash. This can have the knock-on benefit of reducing your working capital.
Use technology and automation: Financial management software can help streamline your processes, improve accuracy and optimise your working capital.

As you can see, working capital is a big but very useful topic.