Negosentro | 3 Tips for Acquiring Working Capital | There are two key metrics that a company must manage to ensure that they thrive, no matter what the economy is doing.
The two key metrics are the company’s working capital and its cash flow. Cash flow refers to the amount of money that a company generates and expends in a particular financial year. A company’s working capital is calculated by deducting its current liabilities from its current assets.
By calculating your working capital, you’ll be able to see whether or not the company will be able to meet its obligations for the next few months. By keeping track of your working capital and managing your cash flow, your business has the best opportunity to weather any economic downturns and other potential threats to its survival.
So what is working capital?
Working Capital: What is it and Why is it Important?
Working capital refers to the amount of money that is left over after deducting current liabilities from current assets. Your current assets include things like cash on hand, cash in the bank, your inventory and any other assets, whether they’re physical or paper assets that you can convert quickly into cash.
Current liabilities are general expenses and is the amount that you owe falling due within the following 12-month period. This will include accounts payable for items such as your operating expenses, rent, stock, etc.
Current Assets = $200,000
Current Liabilities = $100 000
Working Capital = $100,000
If we reflect that as a ratio, often referred to as the current ratio, we will divide our current liabilities into our current assets to get a ratio of 2 to 1. This is traditionally seen as a healthy current asset ratio.
Working Capital Ratio and What It Means
The working capital ratio is also called the current ratio. It is used by financial institutions and by management, to assess if a company can pay its debts in the short term.
The closer the ratio gets to 1:1, the more difficult it will be for a business to meet its short-term financial obligations. It is under these circumstances that management must attempt to improve the current asset ratio by increasing current assets and decreasing current liabilities.
Net Working Capital vs. Gross Working Capital
Sometimes, you will hear current assets referred to as gross working capital. This term is used when describing the total of all current assets that a business may have.
How to Calculate Working Capital
Net working capital is the difference between current assets and current liabilities.
Gross working capital is not a good indication of whether the company can pay its debts or commentary on its liquidity.
Gross working capital only looks at the value of the current assets over the following 12-month period.
To get a truer picture of what the company’s liquidity is actually like, one has to deduct the current liabilities from the gross working capital to obtain the net working capital value.
If a company is in good financial condition, working capital calculations should return a positive number. The closer the number gets to zero, the more difficult it will be for the company to meet its obligations.
Under these conditions, a company needs to consider working capital solutions and make decisions on how it can raise additional funding.
When Do You Need Working Capital?
There are a variety of reasons why a company would require working capital.
The most obvious reason is when a company runs short of cash flow needed to meet its short-term obligations, it needs to raise working capital for the business to survive.
The options open to management are either to increase current assets or decrease liabilities. A combination of these two approaches will have the best outcome.
To increase current assets, a company can raise financing either through borrowings against fixed assets or property, raising an overdraft, taking out a business loan, or converting some of the company’s fixed assets into cash.
To reduce liabilities, a company can convert its stock or inventory into cash and utilize the cash to pay off outstanding creditors.
Let’s take a closer look at how management can improve their net working capital position.
What are the Main Sources of Working Capital? (How to Address Negative Working Capital)
Management’s job is to come up with innovative ways to improve net working capital. Let’s start with some of the most common and quick solutions to resolve liquidity issues:
- Reduce Outstanding Debts
- Require a Deposit on all orders
- Apply for financing
Your accounts receivable list should be split into current, 30-days, 60-days, 90-days, and beyond. Depending on your industry, it may be usual for your debtors to pay their accounts within 30 or 60 days.
Reduce Outstanding Debts
In well-managed companies, the accounts receivable department should constantly report on any accounts that are not being kept up to date. If an account is allowed to exceed either its credit limit or its contracted payment terms, then a process of addressing the situation needs to be laid out clearly.
A documented process of reminders, phone calls, emails, and letters should be followed so that management can decide on how to proceed with the collection process. In a worst-case scenario, a client or customer who fails to pay their bills on time may be prevented from buying additional goods or services and in extreme cases handed over to a collections agency to recover the outstanding amount.
If your cash flow situation is bad and you are looking for ways to increase cash on hand, the next target of your management process could be those clients who are within their contractual repayment terms but can benefit from an early settlement discount. This should form part of the ongoing management of your accounts receivable department as well as being an element of your costing process.
Often it is cheaper to offer a small settlement discount than it is to pay interest on borrowed funds. However, one must be careful not to reduce profit margins to a point where the business becomes unprofitable.
Require a Deposit on New Orders
Depending on the industry that you’re in, it may make sense to demand a deposit on all orders over a certain value. in this way, you can calculate what it would cost you to acquire the raw materials to fulfill the order and cover those costs first.
This is a quick way to increase your working capital while still retaining a good relationship with your clients.
As a way of thanking your clients for reducing the risk of placing the order, you can offer a somewhat discounted price on the finished goods, depending on how much deposit you’re asking for.
Applying for Financing
When a company applies for business funding, it must calculate exactly how much is required. Avoid applying for too much credit as this will increase the cost of funds which they may not be able to convert into sales.
By checking the fine print on all financing agreements, you can ensure that there are no hidden fees or costs that can increase the total cost of funding. Consider working with iKahn Capital to get your business started.