Effective working capital management is a key component of smooth business operations, healthy cash flow and realistic growth plans. There is a close relationship between working capital and cash flow, and getting the balance right requires a strategic approach. 

We explore the principles of working capital management, ratios and metrics to monitor, key strategies and when to leverage working capital finance, such as lines of credit, invoice finance and flexible business loans.

What is working capital management?

Working capital management is the process of managing your company's short-term assets and liabilities to give you enough money to cover your expenses, while also making sure that you don't overburden your business with debt.

The main types of working capital

There are two main types of working capital your business should consider when strategically managing its finances. Here is a brief overview:

• Permanent working capital: The minimum level of working capital a business must maintain at all times to operate smoothly. It represents the baseline investment in current assets, such as cash, inventory and receivables, needed to cover ongoing operating costs.
• Temporary working capital: The additional working capital needed during peak periods or seasonal fluctuations. It rises and falls with business activity, like when production increases, inventory levels grow, or more customer credit is extended. This measure is useful for assessing the financial demands of specific projects or during busy periods.

When assessing working capital, you should look at various calculations, such as gross working capital and net working capital.

The figures will be either positive or negative. Negative working capital means your liabilities exceed your assets, which is something you want to avoid for significant periods. However, overly positive working capital is not ideal either, as it’s a sign your business has too much cash tied up in inventory or outstanding receivables or is underinvesting in business growth opportunities. Learn more in our guide to working capital and how to calculate it. 

What are the key components of working capital management?

There are three main components of working capital management: cash flow, inventory and accounts receivable. We discuss each of these factors in more detail below:

Available cash flow

You need to ensure you have enough cash to cover your expenses, both in the short and long term. You can monitor this via your company’s cash flow statement. If your business is experiencing cash flow problems, you’ll need to address these issues and find the root cause as soon as possible. 

Some common reasons for poor cash flow include:

• Incorrect pricing
• Poor financial planning
• Seasonality in revenue
• Unexpected expenses

Cash flow gaps are not uncommon for small businesses, especially those operating in sectors like retail, hospitality, construction and professional services, which are either heavily influenced by seasonality or impacted by lengthy payment schedules.

The important thing is how you handle them. Working capital finance and cash flow loans are a way to quickly plug the gaps. They’re fast and flexible sources of finance to cover expenses in tricky periods or certain seasons of the year. 

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Current inventory

Your inventory plays a key role in working capital management. It’s a difficult balancing act at times, but you need to ensure you don't have too much or too little stock, as it can affect your cash flow and profitability. 

Be aware that too many slow-selling items will tie up your cash and reduce your liquidity. You should understand the average length of time it takes to sell your products while monitoring inventory levels carefully, with the support of smart digital software, to forecast and meet demand and avoid stockouts and overstocking. 

Accounts receivable

Collecting payments as quickly as possible contributes to good working capital management. If your customers are slow to pay or your credit terms are too long, then it may impact your cash flow and put your business at risk of defaulting on payments (unless you have invoice financing in place). 

There are dedicated tools you can use to automate invoice chasing, incentives to offer clients to pay early or B2B buy-now-pay-later solutions, like iwocaPay, which offer a mutually beneficial solution, where your clients can spread payments across monthly instalments while you get paid upfront every time.

How to calculate working capital

The main working capital formula is simple: 

Working capital = current assets - current liabilities. 

This offers a snapshot of your company's liquidity and helps you identify where you may need to improve your cash flow. For example, if your current assets are £100,000 and your current liabilities are £80,000, your working capital would be £20,000. This means that you have enough cash to cover your short-term expenses, but you may want to increase this number if you’re planning to expand in the future.

What are the best working capital ratios to monitor?

Once you’ve calculated your working capital, analysing key areas of working capital management is vital to see how well your business is performing and where to make improvements. Here are the main working capital ratios and metrics to monitor:

• Current ratio: Measuring liquidity by comparing current assets to current liabilities. A ratio above 1 indicates you have enough short-term assets to cover what’s owed. This ratio shows the buffer you have for any unexpected expenses or revenue dips, which is crucial when cash reserves are limited.
• Quick ratio (acid test ratio): Assessing your ability to meet short-term obligations using the most liquid assets (excluding inventory). This ratio highlights how quickly you can respond to your cash needs without relying on selling inventory, which is key for businesses with slow-moving stock.
• Cash conversion cycle (CCC): Demonstrating how long it takes to turn inventory and receivables into cash. A shorter CCC improves liquidity and reduces the risk of cash shortages and reliance on capital borrowing, freeing up money for various operations and growth plans.
• Turnover ratio: Measuring how many times inventory is sold and replaced over a set period. Higher turnover indicates efficient inventory management. Monitoring your turnover ratio can help avoid tying up too much cash in stock and reveal whether inventory levels are aligned with customer demand.
• Days inventory outstanding (DIO): The average number of days inventory is in place before being sold. A lower DIO means faster inventory movement, so reducing it gives you quicker access to cash that’s otherwise tied up in stock, improving liquidity and reducing storage costs and wastage.
• Days payable outstanding (DPO): Indicating how long (on average) it takes you to pay your suppliers. A higher DPO means you keep cash in the business for longer. Managing this strategically, including negotiating longer payment terms with suppliers, can ease cash-flow pressure.
• Working capital turnover (WCT): Measuring how well your business uses its working capital to generate sales (essentially, your sales ÷ working capital). This ratio can help dictate how and when you need to improve operational efficiency, with the higher the value, the more efficient your business is in utilising working capital for growth. 

How to optimise your working capital management 

Managing your working capital effectively is crucial to keep your business running smoothly and ensure healthy cash flow to meet your obligations, invest in growth and adapt to changes in your market, revenue and costs.

You need a strategic approach. Below, we offer 6 practical steps to optimise your working capital:

1. Closely monitor and manage your inventory levels

You should use demand forecasting, just-in-time (JIT) methods and regular stock reviews to avoid costly overstocking or stockouts. The longer your stock sits on shelves, the more cash is tied up and unavailable for other operational needs.

Well-managed inventory levels shorten the cash cycle, improve efficiency, reduce holding costs and ensure you have the right products available to meet customer demand, while freeing up capital for other activities.

2. Improve receivables collection

There are various ways to improve receivables collection, including tightening credit policies, offering early-payment incentives to customers and adopting efficient invoicing processes. Faster collections increase the cash available for day-to-day operations or reinvestment.

Seek to establish clear credit terms and communication with customers, and chase overdue invoices promptly, with automated follow-ups. Strong receivables management reduces risks of oversight, late client payments and cash flow gaps.

3. Strengthen supplier relationships 

Good supplier relationships lead to consistency and better trade credit solutions. Aim to negotiate longer payment terms or more flexible conditions while maintaining trust and reliability with suppliers.

While extended payment terms mean you retain cash for longer, strong supplier relationships can also result in better pricing and discounts for early, bulk or subscription payments, which reduce cost risks and support sustainable growth.

4. Enhance cash flow forecasting

Regular and accurate cash flow forecasting provides a better view of your financial health, helping you anticipate potential shortfalls and adapt to changing conditions, so you can proactively allocate resources.

Enhancing your forecasting capabilities, with templates and advanced software, helps small businesses minimise risk, avoid nasty surprises and make more informed spending decisions. You can then implement actions, such as pricing adjustments and finding cost savings in different business areas.

5. Streamline operations to reduce costs

Maintaining operational efficiency is a constant priority for SMEs, as streamlining processes helps reduce waste, work smarter and save money. Leaner operations free up more cash, improve margins and strengthen your business resilience against market/economic fluctuations, while offering room for reinvestment in marketing, product development and other growth opportunities.

Seek to adopt new technologies and modernise systems and processes to increase efficiency, lower operational expenses and protect working capital.

6. Use short-term financing strategically

While organic working capital management helps to ease cash flow pressures and free up liquidity for key operational needs and investments, SMEs will inevitably need external finance support from time to time to cover certain costs and move to the next growth stage.

When used carefully and strategically, short-term funding solutions can boost working capital management with affordable borrowing that increases your purchasing power and plugs cash flow gaps when required. 

Using working capital loans to support cash flow and operational efficiency

Working capital loans can be powerful facilities for managing cash flow, improving operational efficiency and supporting business expansion, debt consolidation or inventory/asset purchases. 

They’re typically used to cover short-term business finance needs, offering fast and flexible access to funds. There are several types of working capital loans, such as:

• Business lines of credit: A revolving credit facility that enables businesses to draw funds from an agreed limit as and when required, only paying interest on what they use.
• Merchant cash advances: A form of revenue-based funding offering a lump sum of capital to be repaid as a percentage of future card sales.
• Invoice finance (factoring or discounting): An advance of pending client invoice payments to unlock cash tied up in receivables, providing quick access to funds needed for business use.
• Inventory finance: A loan for purchasing new stock (particularly in peak seasons) to meet demand, with the loan being secured against your inventory. 
• Unsecured flexible business loans: Alternative loan solutions from digital lenders, which don’t require collateral and provide flexible terms, rapid online applications/ approvals and repayments tailored to your cash flow.   

iwoca is a leading business loan provider for UK SMEs, helping businesses with working capital management and powering growth plans. Our flexible and hassle-free business loans are designed to address working capital needs and provide quick access to funds, with affordable monthly repayment terms. 

You can apply online in minutes to borrow £1,000 to £1 million for days, weeks or months (up to 60 months) and get a decision within 24 hours. We don’t charge for early repayments, and you only pay interest on the funds you use.

Find out how to apply for an iwoca Flexi-Loan or use our business loan calculator to work out your likely repayments.