What is Working Capital Management?

By | January 7, 2022

Working capital management – defined as current assets minus current liabilities – is a business tool that helps companies use current assets effectively and maintain sufficient cash flow to meet short-term goals and obligations.

By managing working capital effectively, companies can free up cash that would otherwise be trapped on their balance sheets . As a result, they may be able to reduce the need for external borrowing, expand their business, fund mergers or acquisitions , or invest in R&D.

Working capital is vital to the health of any business, but managing it effectively is a balancing act. Companies need to have enough cash available to cover planned and unforeseen expenses , while also making the best use of the available funds.

This is achieved by effective management of accounts payable, receivable, inventory, and cash.

Working capital formula

Working capital is calculated by subtracting current liabilities from current assets. This means that the working capital formula can be described as follows:

Working capital = current assets – current liabilities

Current assets include assets such as cash and receivables, and current liabilities include accounts payable.

Other important working capital metrics include:

  • Days Sales Outstanding (DSO)   – the average number of days it takes enterprise customers to pay their invoices.
  • Days Payables Outstanding (DPO)   – the average number of days it takes a company to pay its suppliers.
  • Days Inventory Outstanding (DIO)   – the average number of days it takes a company to sell its inventory.
  • Cash Conversion Cycle (CCC)   – the average time it takes a company to convert its investment in inventory into cash.

CCC is calculated as follows:

CCC = DIO + DSO – DPO

The shorter a company’s CCC, the faster it converts cash into inventory and then back into cash.

Companies can reduce their cash conversion cycles in three ways: by asking customers to pay faster (reduced DSO), extending payment terms to suppliers (increasing DPO) or reducing inventory holding time (reducing DIO).

Objectives of working capital management

Working capital is an important metric that businesses should pay attention to, as it represents the amount of capital they have available to make payments, cover unexpected costs, and ensure business runs as usual.

However, working capital management is not that simple, and there are several objectives of a working capital management program, including:

1. Fulfilling obligations

Working capital management must always ensure that the business has sufficient liquidity to meet its short-term obligations, often by collecting payments from customers sooner or by extending the payment terms of suppliers.

Unexpected costs can also be considered as liabilities, so this also needs to be taken into account in the working capital management approach.

2. Developing business

As such, it’s also important to use your short-term assets effectively, whether that means supporting global expansion or investing in R&D.

If your company’s assets are tied up in inventory or accounts payable, the business may not be as profitable as it should be. In other words, an overly cautious working capital management approach is not optimal.

3. Optimizing capital performance

Another goal of working capital management is to optimize the efficient use of capital – either by minimizing the cost of capital or maximizing the return on capital.

The former can be achieved by recovering the capital currently tied up to reduce the need for borrowing, while the latter involves ensuring the ROI of the reserve capital exceeds the average cost of financing it.

Effective working capital management

Speeding up the CCC can improve a company’s working capital position, but it may also have other consequences. For example, there is a risk that reducing inventory levels could negatively impact your ability to fulfill orders.

In the case of DPOs, your accounts payable are also receivables from your suppliers – so if you pay your suppliers later, you can increase your own working capital at the expense of your suppliers’ working capital.

This may have a negative impact on your relationship with the supplier and may even make it difficult for a cash-strapped supplier to fulfill your order on time.

Therefore, effective working capital management means taking steps to improve your company’s working capital position without triggering adverse consequences elsewhere in your supply chain. This may include reducing DSO by implementing a more efficient invoicing process, so customers receive your invoices faster. Or it may mean adopting an early payment program that allows your suppliers to receive payments faster than they otherwise would.

Working capital management solutions

Companies can use a variety of solutions to support effective working capital management, both for themselves and for their suppliers. This includes:

1. Electronic invoice

Electronic invoicing can help companies achieve working capital benefits. By streamlining the invoicing process, you can reduce the risk of errors, automate manual processes, and ensure that your customers receive your invoices as early as possible – which can ultimately mean you get paid faster.

Electronic invoicing methods can allow companies to convert purchase orders into invoices automatically or send invoices in bulk using system-to-system integration.

2. Cash flow forecast

By forecasting future cash flows – such as accounts payable and receivable – companies can plan for future cash gaps and make better use of surpluses. The more accurately you can predict your future cash flows, the better informed your working capital management decisions will be.

3. Supply chain finance

For buyers, supply chain financing – also known as factoring – is a way of offering suppliers an initial payment through one or more third-party funders.

Suppliers can increase their DSO by getting paid faster with lower funding costs – while buyers can maintain their own working capital by paying according to agreed payment terms.

4. Dynamic discount

Dynamic discounts are another solution that buyers can use to provide early payments to suppliers – but this time there is no external funder, as the program is funded by buyers through early payment discounts. Like supply chain finance, it allows suppliers to reduce their DSO.

What’s more, it allows buyers to achieve attractive risk-free returns on their excess money.

5. Flexible funding

Working capital providers that offer flexible funding allow buyers to move seamlessly between supply chain financing and a dynamic discount model, meaning companies can adapt to their various working capital needs while continuing to support their suppliers.