Working Capital Management
, and half of the US workforce is employed by a small business. Each one of those companies needs working capital—aka, cash on hand to pay expenses—in order to survive. But at what point does a business choose to stop keeping cash in savings and start investing in growth and new opportunities? Should a business use financing to pay daily expenses? How can financing play a role to jump-start growth to the next level? All these concerns are part of the strategy behind working capital management.
What is Working Capital Management?
Working capital management is the tracking and prioritization of short-term cash flow at a business. It is a comparison between income the business is owed or has already earned (assets) and what expenses need to be paid (liabilities). Working capital management helps business owners make decisions in alignment with their goals and a realistic view of the financial situation they are in.
What are the 4 Main Components of Working Capital?
The four main components of working capital are accounts receivable, accounts payable, inventory, and cash and bank balances.
The current assets of a business, compared to its debts and liabilities, are a rough picture of its working capital.
What are the 3 Approaches to Working Capital Management?
to working capital management. These are a matching approach, a conservative approach, and an aggressive approach.
In a matching approach to working capital management (also known as a hedging approach), the type of capital used for funding is matched to the expense or asset being paid for. Long-term investments like real estate are paid using long-term financing like a loan, while short-term expenses like operating expenses are paid with revenue or with short-term financing.
In a conservative approach to working capital management, even a portion of operations expenses and short-term costs are financed with long-term sources of revenue. This keeps more liquidity available day-to-day to keep the business agile in the face of market changes. Excess cash may also be invested in short-term securities which are in turn sold when funds are needed.
In an aggressive approach to working capital management, the short-term availability of funds is minimal, whether due to the revenue cycle or lots of investments. Only funding to cover the current expenses is maintained and there is not much cushion for changes in demands for capital. In seasonal businesses or periods of growth, short-term financing or other funding infusions bridge the gap.
No matter the chosen approach, the objectives of working capital management remain the same: maintaining operations, spending as little as possible to achieve goals and quality standards, and maximizing return on any investments. All this adds up to the work being done and the revenue being earned.
Working capital management is concerned with risk management as much as the dollars and cents. Every time something is paid with cash, that reduces the company’s cushion of savings. The amount of risk a business is willing to assume is part of how the company decides to use cash for an expense now or save it for a rainy day. Another factor to consider is the company’s confidence it can get financing. Credit scores and the industry of operation both impact whether alternative short-term financing is available to a small business in a time of need.
Working Capital Management Formula
Companies measure the state of their working capital with a ratio. Using the working capital ratio formula, a business with a score of 1 or higher is healthy and attractive to investors, while those with a ratio of less than 1 would be considered risky.
To calculate the ratio, add up the value of the current assets of the business, including account balances, real estate, other property, and other investments. Divide the total sum of assets the business has by the amount of debt the business owes. For example, if the business had $400,000 in assets and $250,000 in expenses and debts, its working capital management ratio would be 1.6.
$400,000 (total assets) / $250,000 (total liabilities) = 1.6 (working capital ratio)
This is a healthy working capital management ratio! This business is poised to grow and diversify investments.
Working Capital Cycle Formula
Another calculation business owners might be concerned with is the working capital cycle formula. The working capital cycle is how many days pass between delivery of a service or product and the day the business gets paid. Some businesses have 30-day payment terms, others have annual billing cycles, and still others are paid on completion of work or delivery of a product.
But that is just one element of the working capital cycle. The other part is the number of days the business has to pay the suppliers or employees that allow them to deliver the work. Both these timelines must be balanced to achieve a functioning working capital cycle. Let’s unpack another simple working capital management example to show how this balance can be a challenge:
A construction management company is leading the work on site to develop a strip mall. They receive an initial deposit from the developer and will be paid as different milestones on the project are achieved, plus a final amount on completion. But to execute on the project, the construction management company must pay many invoices and expenses, making sure there is capital for labor and raw materials like cement, lumber, and machinery. Different subcontractors on the project have specialized needs and there will also be barriers that require resources to overcome which can’t be planned ahead for.
In this working capital cycle, the construction management company is receiving payment once every 30 days or so, but has to pay invoices on demand for inventory, bi-weekly for labor—it begins to become quite complicated.
Overall, it’s pretty normal for a business to be in the negative for a short time waiting for payment. This is because the business has covered the expenses of providing the service or product, and is now waiting for payment to restore balance. In those situations, acquiring short-term business financing through a partner like
helps businesses get the capital they need today and pay it back over the short-term, or right away once the funds are on hand.
Working Capital Statement
Another working capital requirement for a business may be a working capital statement. This is a statement by the leaders of a company that they believe they have enough working capital, or they have a plan to get it. These statements might be issued to shareholders, released as part of transactions, or disclosed during pitches for investment.
How Do You Solve Working Capital Management Problems?
Working capital management problems are caused by a variety of issues. The first step is identifying the cause of the problems. This could be:
One of these three is likely to be the bottleneck in the flow of working capital for a successful business. Exploring these internal administrative processes also offers an opportunity for analysis of the budget. Deciding where cash is needed and why is essential to reset working capital management and define goals and KPIs for after the problems are solved.
Strategic approaches to working capital management moving forward are defined by what the business wants to pay for using cash on hand, and what will be financed. As mentioned earlier, some companies use long-term financing for day-to-day operations and others pay for everything using cash on hand. Many operate somewhere in between. And every company is subject to the unpredictable whims and disruptions of the market, and is sometimes graced with fantastic opportunities they want to act on.
Fund Dreams and the Day-to-Day with Backd
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Hire more employees, buy new equipment, invest in repairs to a building, launch that new ad campaign, and simply sleep better at night. Backd has your back to make it possible.
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