Friday, June 10 2022

Working capital is defined as the difference between current assets and current liabilities of the business. Lenders take this into account when assessing whether or not they allow you to borrow money. This makes working capital a very glaring indicator of your financial health.

As an entrepreneur, it is important to learn how to manage effectively working capital. Having an effective working capital management process in place will ensure the profitability and solvency of your business. Not only does this keep your cash flow positive, but working capital management also ensures your business is funded when needed.

The three essential “ratios” in working capital management

Learning to manage your working capital always starts with the three important ratios. the three working capital ratios are, namely:

The current ratio is the result of dividing current assets and current liabilities. The term “current” refers to assets that can be liquidated within one year. Likewise, current liabilities are debts and obligations that fall due within a year. This ratio indicates how well the company can settle its short-term obligations or those that fall due in less than a year.

The collection rate indicates how efficiently the business can liquidate pending invoices or accounts receivable. It is also in part an indicator of the company’s ability to generate revenue from its customers over a period of time.

  • The inventory turnover rate

The inventory turnover ratio measures the average time that a business can convert its existing inventory to cash. It can also indicate how long a company’s working capital is tied up in inventory before it enters cash flow. These two elements reflect the inventory management capabilities of your business.

These three elements are used by lenders to assess the creditworthiness of your business, in addition to checking your business or even your personal credit score. Your goal in managing working capital then is to manage these three ratios and keep them at healthy levels.

Steps you can take to make working capital management more efficient

Managing working capital is a constantly evolving process. The business landscape is inherently volatile. Surviving in this environment means being proactive in your management processes. You cannot expect to overcome sudden changes just by reacting to them. Instead, you should anticipate instability to some extent.

How can a small business like yours be proactive? Here are some changes you would like to put in place for your working capital management.

Set up accounting and inventory software

It doesn’t matter if your inventory is moving at a slow or fast pace. You can benefit from using software for accounting and inventory. Programs like Quickbooks can dramatically streamline all of your management and accounting processes.

Using software makes tracking your three working capital management ratios easier and more convenient. All the data you need is right at your fingertips. The software gathers all the relevant data and generates the necessary reports within minutes. You can focus more on discussing with your team what steps you can take to improve the three ratios than on manually assembling the necessary data.

Liquidate non-productive assets

You invest in assets because they are, by nature, intended to earn you income. However, some assets over time become unable to generate income for your business. This can happen for various reasons. For example, the equipment you use can become obsolete or unusable as maintenance and repairs become very expensive.

Assets become unproductive at this point. Unfortunately, they tie up working capital without giving anything back. Your best course of action is to liquidate these assets. Selling them assets will generate cash that you can transfer to your reserves. You can also use the proceeds to settle short-term debts and improve your current ratio.

Create a request for parked inventory

Inventory that sits on your shelves for a long time also becomes a non-performing asset. They will also need to be converted to cash as soon as possible. You should also consider the shelf life of these items.

These consumables become bad stock if they are left unsold beyond their expiration dates. You can think of them as past due debts where the borrower is unable to repay the loan. You can’t make money with bad stocks, which turn from asset to liability on your balance sheet.

You can create demand for items that have been on your shelves for over a year by running promotional events. For example, you can group together several related items such as pasta, meat sauce, and cheese. You can sell them at a special discounted price which is cheaper than their combined prices. While you can sell them at a loss, promotional events can dramatically improve your inventory turnover rate.

Improve invoice tracking and collection

Your bills could pile up if there isn’t an effective tracking system in place. It is essential to separate accounts receivable data by due date. This helps you identify which invoices are almost due and need to be recalled. The system will also highlight those who are overdue; these must be prioritized for collection.

As mentioned earlier, accounting software can go a long way in streamlining the processes of generating and collecting invoices. Most of these applications are also capable of sending invoices to their recipients.

Without effective follow-up, you will have a hard time processing invoices in a consistent and logical manner. You could end up with missing invoices that are overdue. Worse yet, you might end up not collecting some of your bills at all. This can adversely affect your collection rate.

The bottom line

Your working capital indicates the ability of your business to maintain operations. It quantifies whether the business has enough cash to cover operating expenses and existing debt, or whether it is simply breaking even. Lenders typically use working capital as one of their criteria to assess borrower’s eligibility for short-term debt.

An effective working capital management process is mandatory for any business, large or small. This process should improve the three working capital ratios, namely the current ratio, the inventory turnover ratio and the recovery ratio. There are many ways to effectively manage working capital, including using accounting software, promotional events to move inventory, and an invoice tracking mechanism.

A business that knows how to manage its working capital has an exceptional chance of obtaining funding approval and is in better financial health than those that cannot. They are also on the right track to succeed in their chosen niche.

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