Working Capital — The Good, the Bad, and the Ugly 

Working capital is the excess of current assets over current liabilities and is a financial measure of liquidity or ability of a business to meet its obligations.  Current assets include cash, accounts receivable, inventory and other assets that are expected to be converted to cash within 12 months. Current liabilities include accounts payable and accrued expenses for salaries, taxes, interest as well as loan payments and other liabilities due within 12 months.

The GOOD news is that effective management of working capital can strengthen a company by providing funds needed to support operations as well as reduce financing costs and dependence on external sources of financing.

The BAD news is that poor management of working capital can weaken a company by draining cash resources required to meet payment obligations, resulting in the need to rely on costly outside debt or equity financing.

The even more UGLY news is that a company that has mismanaged working capital to the extent that it cannot meet its current obligations, and is not able to secure additional financing, may ultimately face an unfriendly acquisition, bankruptcy or liquidation.

The following are some financial metrics that should be tracked and reviewed monthly to alert management of negative trends developing in working capital so that appropriate corrective actions can be taken:

  • Current Ratio = Current Assets / Current Liabilities
  • Quick Ratio = (Current Assets – Inventory) / Current Liabilities)
  • Receivables (Days) = Accounts Receivable / Average Daily Sales
  • Inventory (Days) =Inventory / Average Daily Cost of Sales
  • Payables (Days) = Accounts Payable / Average Daily Purchases

Optimal levels of working capital and associated metrics may vary considerably according to the particular industry.  Such factors as the seasonality of sales and industry norms may have a significant bearing on working capital requirements.

The following are some of the actions that management should consider taking to improve working capital:

  • Establish firm credit policies and check customer credit references
  • Require advance payments or deposits from customers
  • Encourage credit card payments
  • Invoice customers promptly and accurately to reduce collection cycle and disputes
  • Contact customers prior to invoice due date to address potential payment issues
  • Offer customers discounts for early payment
  • Adopt “just in time” inventory procedures for purchase of raw materials and components
  • Reduce inventory levels and monitor closely to minimize excess or slow moving stock
  • Negotiate with suppliers for longer payment terms
  • Negotiate with suppliers to maintain inventory at their location

Although the above mentioned actions can improve working capital management, careful consideration must be given toward weighing the potential negative consequences certain actions may have in other areas of the business. Credit card payments and customer discounts are expensive sources of financing. Advance payment requirements and reductions in inventory levels may result in lost sales opportunities.  Extended payments to suppliers may jeopardize supplier relations.

B2B CFO® Partners are experienced in monitoring working capital and implementing the appropriate changes that will strengthen the overall financial condition of the company. Management of working capital is another example of how we reduce stress on the business owner and allow the him/her to focus on business development and other critical activities that add value to the business.  To learn more about strengthening your company through effective working capital management, give me a call at 203-545-6186,

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