Running a business means you have to keep in mind a number of things. You have to ensure that your employees are following company rules, that revenue is steady and that you have sufficient cash flow. Monitoring your company’s assets and liabilities is what we call working capital management.
Working capital management is defined as a set of activities performed by a business to ensure that it has enough resources for its day-to-day operating expenses. This is done while keeping resources invested productively.
As a business owner, you need to be able to manage your working capital effectively. This will prevent any gaps in cash flow that you are not aware of.
In this article, we look at working capital management and how it can be achieved within your business.
Why Is Working Capital Management Important?
It’s important for businesses to practice working capital management because it’s a strategy for ensuring a business has money to cover its routine expenses, debts, unexpected costs and basic materials. Working capital management helps you minimise the money your business spends and maximises your return on investment. Additionally, it helps you improve your company’s earnings and profits.
The basis of working capital management is that it will help your company avoid any financial problems, increase profitability, improve the value of your business and maintain an advantage over your competition.
Ratios for Working Capital Management
There are three different ratios you can use as tools for managing your working capital. The ratios are as follows:
Current Ratio
The current ratio is used as an indicator of your company’s financial health and ability to meet its short-term financial obligations. The current ratio is calculated using this formula: current assets ÷ current liabilities = current ratio.
Usually, if your company has a current ratio below 1:0 it means that your liquid assets might not cover your upcoming debts. A current ratio between 1:2 and 2:0 is more desirable and a ratio greater than 2:0 suggests that your company is not managing its working capital effectively.
Collection Ratio
The collection ratio is used to show how effective your company is at collecting payment after a credit transaction. It can also show how efficiently your business is managing its accounts receivable.
The collection ratio is calculated using this calculation: (number of days in an accounting period x average amount of outstanding accounts receivable) ÷ total amount of net credit sales during the accounting period.
If your collection ratio is low, it means your cash flow is more efficient. The collection ratio is also referred to as that day’s outstanding sales.
Inventory Turnover Ratio
An inventory turnover ratio shows how quickly your company’s inventory is being used and replaced. The ratio can help your business avoid having capital stuck in inventory that is not being bought which can cause cash flow problems.
You can calculate your inventory turnover ratio using this formula: cost of goods ÷ average balance sheet inventory = inventory turnover ratio. A low ratio shows your business’ inventory levels are excessive. A higher ratio can indicate that your inventory levels are decent.
How to Manage Your Working Capital
There are a few ways you can improve and manage your working capital. Some of the ways include:
Manage Your Inventory
Managing your inventory can improve your working capital and have a positive impact on your business’s accounts receivables, accounts payables, operations and growth. Managing your inventory includes:
- Reducing slow-moving inventory.
- Increasing your inventory turnover.
- Avoiding overstocking inventory.
Managing your inventory will show you the number of days inventory stays on your shelves before it is sold. You can manage your inventory the old-fashioned way or you can use inventory management software to automate the process.
Manage Your Debtors
You can make sure money is coming in on time by looking at the level of credit you are offering to your debtors. This will ensure that there is an appropriate time between payments and can help you improve your working capital.
You can implement credit checks and credit control processes to avoid late payments from your debtors.
Evaluate Your Payment Collection Systems
To reduce the time between payments, you can implement a collection system or reassess your invoicing process. Integrating an electronic invoice system can shorten the time between payments. This evaluation can help reduce or eliminate any inefficiencies that may cause delays in receiving payments.
Predict Your Future Cash Flows
Predicting your future cash flows such as payables and receivables can help you better manage your working capital. This will help your business develop a strategic business plan for upcoming expenses or make better use of any extra money.
To forecast your future cash flows for your business, you will be able to make more informed decisions on your capital management.
Using this article, you can effectively manage your working capital. Being able to manage your working capital will ensure that you have enough cash for any unexpected occurrences.
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Running a business means you have to keep in mind a number of things. You have to ensure that your employees are following company rules, that revenue is steady and Read More
