Many businesses measure their success in terms of sales, but a better indicator is profitability. Turning a profit after paying for expenses means that a business is achieving its financial goals. But in order to consistently yield profits, the business needs to have liquidity.
Even if sales are sky-high, the bottom line can’t grow unless there is enough cash to fund and maintain operations to fulfill all those orders. There is, however, a tried and true method to maintaining liquidity while expanding a business: managing working capital knowledgeably and efficiently.
Cautious with cash
Working capital is the amount of accessible cash you need to support short-term business operations. The traditional way to measure liquidity is current assets minus current liabilities equals working capital. Regularly calculating working capital can help a business’s leadership team answer questions such as:
- Are there enough assets to cover current obligations?
- How fast could those assets be converted to cash if needed?
- What short-term assets are available for loan collateral?
Another way to evaluate liquidity is the working capital ratio: current assets divided by current liabilities. A healthy working capital ratio varies from industry to industry, but it’s generally considered to be 1.5 to 2. A ratio below 1.0 typically signals impending liquidity problems.
A third perspective is to compare working capital to total assets and annual revenue. From this angle, working capital becomes a measure of efficiency.
Costs and credit
The amount of working capital a company needs, or its working capital requirement, depends on the costs of its sales cycle, operational expenses and current debt payments. Fundamentally, there must be enough working capital to finance the gap between payments from customers and payments to suppliers, vendors, lenders and others.
High liquidity generally equates with low credit risk. But having too much cash tied up in working capital may detract from important growth initiatives such as:
- expanding into new markets,
- buying better equipment or technology,
- launching new products or services, and
- paying down debt.
Failure to pursue capital investment opportunities can also compromise business value in the long run.
Focus on these factors
The right approach to managing working capital will vary between companies depending on factors such as size, industry, mission and market. In general, to optimize a business’s working capital requirement, focus primarily on the following three key areas:
- Accounts receivable.The faster you collect from customers, the more readily you can manage debt and capitalize on opportunities. Possible solutions include tighter credit policies, early bird discounts, and collections-based sales compensation. Also, improve your administrative processes to eliminate inefficiencies.
- Accounts payable.From a working capital perspective, since liquidity is key, you generally do not want to pay bills earlier than necessary. Except to take advantage of early bird discounts, it’s best to pay bills at or close to their due date. Be careful not to fall into arrears or nonpayment, which could damage your credit rating and reputation.
- Maintaining inventory is a challenge of efficiently managing working capital. Excessive inventory levels may dangerously reduce liquidity because of restocking, storage, obsolescence, insurance and security costs. Conversely, insufficient inventory levels can frustrate customers and hurt sales. Be sure to give your inventory proper time and attention, such as regular technology upgrades and strategic consideration of ideal quantities.
The right balance
A successful business strikes the right balance of sustaining enough liquidity to operate smoothly, while also saving funds for capital investments and maintaining an emergency cash reserve. Management must assess precisely the business’s working capital and consistently work to optimize it.
This material has been prepared for informational purposes only and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
