April 15, 2019
The Importance of Responsible Working Capital Management
Overall, your ability to master working capital management will determine the health, longevity, and overall quality of your business.
Balancing your short-term assets and liabilities is a continuous responsibility. Ultimately, working capital is an immediate requirement that can affect your business’s long-term goals. For example, if you'd like to open another business location, it'll be difficult to do so if you haven’t responsibly budgeted your business’s working capital.
In this post, we’ll explain what working capital is, and will provide tips on how you can implement working capital management best practices.
What Is Working Capital?
Essentially, working capital is the cash flow that you have available to spend on your business’s day-to-day operations. There are several types of working capital that you should be aware of. Check out the definitions of the types of working capital below:Fixed:
Fixed working capital is the financing that your business permanently has access to, such as machinery or property.Regular:
This type of working capital is needed to run daily operations.Reserved:
Reserved capital can be classified as any money you have in addition to your daily needs, that can be used in case of emergencies.Temporary/Variable:
If you own a seasonal business or are affected by an event such as the COVID-19 pandemic, having temporary working capital (or variable working capital) can keep your business afloat while you experience a sales lull. Overall, working capital depends on your business’s operating cycle, which starts when funds leave your company to buy products or services (such as inventory or your monthly cleaning service), to the time it's returned as revenue. It’s important to note that working capital becomes especially important once you’ve spent a large chunk of money and are waiting for it to return to your business. If your business can’t sustain operations during this amount of time, you’re highly unlikely to make enough sales to get your money back. For example, if you can’t afford to pay your rent, purchase inventory, or afford payroll, this could affect your ability to assist customers. In addition, if your business has multiple operating cycles occurring at the same time, the situation can become very stressful. The consequences of poor working capital management can severely affect your business activity. On the other hand, properly managing your working capital guarantees that your business will flourish.
How Can Working Capital Management Affect Your Small Business?
The Good: Improved Credit Score
Repaying debts while generating revenue ensures your operating cycle is funded, and it’ll likely boost your credit score. To raise your credit score, you’ll need pay your rent, vendor bills, and loan payments on-time. This is a perfect example of how responsible working capital management can be rewarding in the long-run. Once you prove that you pay your bills on-time and have a higher credit score, you’ll likely qualify for a lower-rate business loan or line of credit. Plus, it’ll make it easier for you to procure financing in the future, and you’ll have peace-of-mind knowing that your business is in good financial standing.The Bad: Financial Insolvency and Lower Credit Score
When you’re unable to repay debts but are still running your business with low operating costs, creditors will try to get their funds back. If you’ve been in this situation with your personal debts, you know that creditors call you as soon as your delinquency is reported to the credit bureaus. By the time you get a call, your credit score will already be lowered by at least a few points. The longer your debt goes unpaid, the lower your business’s credit score will drop. Ultimately, this digs you deeper into a hole that’s difficult to climb out of and could put your business’s future at risk. To resolve this issue, we suggest asking your creditor to lower the payment amount and increase the payment schedule length until you’re producing more income. This is the responsible way to rectify the situation and will help you avoid bankruptcy.The Good: Increase Your Profits
Did you know that managing your working capital correctly can result in a revenue boom? This means more business assets that you can spend on additional costs, like new equipment, state-of-the-art software, or hiring costs. Plus, this capital can be invested in marketing after operational needs are met, furthering your business growth. Over time, optimizing your working capital to go lower will increase profits over time. Ultimately, you’ll gain a competitive advantage over competitors because your supply chain logistics are working at a lower cost. This will inevitably lead to more customers and higher production value.The Bad: Liquidation of Assets
If you aren't repaying your debts due to low revenue, creditors will try to repossess any collateral you offered in your application. This puts you one step closer to bankruptcy. Even though it feels terrible to let your yacht or other expensive collateral go, think of it as the price of continuing business. After your lender repossesses your collateral, you should be free from most obligations on that debt, allowing you to focus on improving your financial health.The Good: Ability to Face Emergencies
Properly managing working capital should mean that you’ll eventually have some extra funds available. We recommend saving these funds for emergencies, so that you don’t risk being unable to pay for repairs, employee salaries, or other necessary costs in the case of an unforeseen event. Similarly, if you get an unusually high volume of orders, you can use your reserved working capital to quickly deliver. This increases your business’s value and should help you retain your customer base in the long-term.The Worst: Bankruptcy
When revenue is non-existent and your business’s bank account is almost empty, it might seem impossible to stay afloat. Between paying bills, marketing your business, and paying off debt, your funds are no longer fluid. This will make it challenging to repay your debts. Successful working capital management means your business can handle repaying debts when they're due, and that paying back debt isn’t taking too much money out your bank account. If you’re in this position, monitor your spending and debt payment schedules. Optimize operating expenses and your operating cycle for profit. In addition, determine if your short-term debts can convert into longer-term payment schedules with lower payments. And if you have any unpaid balances, follow up right away or sell the invoices for liquid funding.Are You Ready to Tackle Effective Working Capital Management?
The difference between poor and proper working capital management can lead to business success or result in bankruptcy. Although working capital sounds like a “day-to-day” duty, it’s important to involve all stakeholders who oversee the big picture. Knowing how much working capital your business needs to function will vary, but it’s important to deduce this, plan accordingly, and, of course, manage it responsibly. Do you have any tips to share with our readers? Tell us about them in the comment section below!
Editor’s Note: This post was updated for accuracy and comprehensiveness in July 2020.