Business owners track many key performance indicators on a regular basis, but working capital might be the most important of them all.
Working capital is a measurement of current assets minus current liabilities, making it directly correlated to a company’s cash flow. A positive number means that a business may have the ability to invest in new equipment or expand operations. A negative number indicates that a company has more debt than assets, which can be a troubling sign in the long run unless the organization is able to quickly raise revenue. For these reasons, working capital can be seen as the life blood of a business, and it’s important to monitor it regularly.
Let’s take a closer look at how to optimize working capital and put it to good use for your business.
How accounts receivable and accounts payable impact working capital
Because working capital is connected to cash flow, it’s important to examine your processes around money entering and exiting your organization.
In terms of accounts receivable, the key thing to look at is days sales outstanding (DSO), or the number of days on average that it takes your company to collect sales that were made on credit. Identifying your current DSO and understanding why it might increase or decrease over time is a helpful baseline to establish. From there, it’s a good idea to explore receivables solutions that can help you streamline the entire process and convert these accounts to cash as quickly as possible. Look at where bottlenecks may be occurring and what percentage of accounts aren’t being paid at all.
On the other side is accounts payable and the similar days payables outstanding (DPO) metric. As with DSO, you want to establish a DPO baseline and understand why it might change over time. When working with vendors, look to establish payment terms that fit well with your accounts receivable cycle so that you can be assured that you’ll have money on hand to pay bills. You may also want to explore potential discounts that are available, such as for paying a bill early, as well as payables solutions that can unlock efficiencies for your business.
What to do with working capital
Banks will examine cash flow and working capital when deciding whether to extend credit to a business, so maintaining healthy figures is a sound strategy.
If your business has excess working capital, you may want to consider investing some of it back into the business. That can take the form of expanding your physical space, adding new employees or possibly acquiring another company. It could also be a good time to take out a loan, which will allow your business to grow more rapidly in the short term before paying off the debt in the longer term.
The ability to make trade-offs between profits and working capital can be an advantage as well. At times, it’s worth giving up a bit of profit to significantly reduce the amount of capital you have deployed toward business operations or investments. In other situations, it’s better to deploy a bit more capital to achieve higher profits.
All of these business decisions are possible if you’re in a strong working capital position. Consider talking with a business banker to understand where you’re at today and how to maximize your standing in the future.