Working capital management advice for small businesses

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 borrow too much money.

Types of working capital you need to know

Depending on what you’re trying to measure, you may end up looking at different kinds of working capital in your business.

• Permanent Working Capital refers to the minimum amount of capital that you need on an ongoing basis to keep your business running. This is the baseline level of working capital that remains invested in the business at all times and a key number to watch. This ensures you can carry on the basic operational activities of your business, ensuring that there are sufficient current assets such as cash, inventory, and receivables to cover running costs.
• Temporary (Fluctuating) Working Capital is the additional capital required to support the business during peak operational periods or to meet seasonal demands. Unlike permanent working capital, it varies depending on the level of business activity. For example it might rise when you increase production, push for higher inventory levels or extend credit to customers during busy periods. Use this number when you’re gauging the health of a particular project or period.

What are the key components of working capital management?

There are three main factors of working capital management you need to consider when managing your company's working capital - cash flow, inventory and accounts receivable. We discuss each of these factors in more detail below:

Available cash flow

You need to make sure 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 suffering from cash flow problems, then you’ll need to address these issues and find the root cause as soon as possible. Some of the reasons for poor cash flow can be:

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

Cash flow gaps are common for small businesses, but the key differentiator is how you handle them. Cash flow loans can be a fast, effective way to cover expenses when you fall short. Iwoca offers decisions on Flexi-loans in as little as 24 hrs, with no charges for early repayment.

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Current Inventory

Inventory plays a key role when it comes to working capital management. You need to make sure that you don't have too much or too little, as this can affect your cash flow and profitability. You should also be aware of the average length of time it takes you to sell your products. Too many slow-selling items will tie up your cash and reduce your liquidity.

Accounts receivable (money owed)

Collecting payments as quickly as possible contributes to working capital management. If your customer credit terms are too long then it may impact your cash flow and put your business at risk of defaulting on payments. Using customer financing like iwocaPay means that your customers can spread payments across 3 monthly instalments while you get paid upfront every time.

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How to calculate working capital management

The working capital management formula is simple: subtract your current liabilities from your current assets. This will give you a snapshot of your company's liquidity and help 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’s the best working capital ratio?

Once you have calculated your working capital, an analysis of working capital management is important to see how well your business is performing. There are three main working capital ratios you should look at:

• The current ratio: measures your company's liquidity by comparing your current assets to your current liabilities. A ratio of greater than one means that you have more current assets than liabilities, indicating a healthy liquidity position.
• The acid test ratio: measures your company's ability to meet its short-term obligations by comparing your current assets (excluding inventory) to your current liabilities.
• The cash conversion cycle: measures how quickly you can turn your inventory into cash. A shorter cycle indicates better liquidity and a lower risk of running out of money.

How to Optimise Your Working Capital

Managing your working capital effectively is crucial for keeping your business running smoothly and ensuring you have the cash flow needed to meet your obligations and invest in growth

Making sure you have enough liquidity is a matter of managing the various levers that affect your working capital, adapting to changes in your market, revenue and costs.

Cash Flow Management

The first step is making sure you’re keeping an eye on money in and out of your business. Make a habit of regularly reviewing and forecasting your cash flow – costs and income can fluctuate over time, so it's essential to review and update your cash flow figures on a regular basis. 

For example, if the price of raw materials for your products increase, you’ll need to adjust your forecast (and maybe your prices) to account for that. 

Inventory Optimisation

The longer you hold onto stock before it turns into revenue, the less working capital you’ll have available. That’s one of the reasons that many businesses focus on shortening their cash cycle as much as possible. 

Strategies such as just-in-time (JIT) aim to minimise holding costs and reduce excess inventory by ensuring that you only hold the stock you need to sell, rather than being weighed down with excess products. . This ensures that you only keep what you need, freeing up cash for other purposes, like day to day costs.

Accounts Receivable Management

The faster you can get paid, the more working capital you have available to spend when you need it. That will mean being strict with clients, implementing strict credit policies to ensure timely payment.

This doesn’t have to be anything drastic – just clearly define your credit terms at the start of any engagement and enforce them consistently across your client base. This also requires following up promptly on overdue invoices to minimise delays and debtor days. 

Accounts Payable Management

The other side of the coin is managing the money going out of your business – work with your suppliers to set reasonable payment terms that help you retain cash longer so it’s available when you need it.

Sometimes it can even be worth paying earlier, taking advantage of early payment discounts if your cash flow allows to reduce overall expenses.

It also helps to manage your payment schedules strategically, align payments with your cash inflows to maintain liquidity on a day-to-day basis.

Working capital loans

When you have a gap in your working capital, working capital loans can be an essential tool for covering your costs, including supporting expansion, debt consolidation or purchasing inventory. 

They’re typically used to cover the short-term and help businesses to improve cash flow. 

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