Why working capital management is so important for today’s entrepreneurs

As an entrepreneur, managing your business finances is high on your list of priorities. However, for many, this process begins and ends with the balance sheet analysis. This is an erroneous approach that carries the risk of insolvency because it neglects a crucial element: working capital. This part of business finances is related to day-to-day cash requirements. Businesses need funds to operate optimally and these operating costs are only available if there is good working capital management.

Working capital is simply the money a business needs on a regular basis. It funds short-term needs such as material costs, payroll, and a range of other such expenses. Having sufficient working capital is crucial for stability, as it ensures the uninterrupted operation of the business. To easily find out how much of this type of financing is currently available, you can use the working capital formula, which is:

Working capital = Current assets – Current liabilities

The result is a measure of the company’s liquidity, in the short term, and indicates the amount available for expenses. Effective working capital management is essential to ensure there is always enough to support business operations. To learn more about this concept and understand its importance for entrepreneurs, read on.

What is the concept of working capital management?

Working capital management is simply about effectively managing assets and liabilities. This means making the most of both components of working capital. This kind of monitoring is essential for any business as it helps secure cash flow for debts as well as day to day costs. While the basic overview can be quite simple, managing working capital can be complex the deeper you go.

On the one hand, it is based on 3 key ratios, which are the inventory turnover ratio, the collection ratio and the working capital ratio. Here is a brief overview of each.

Working capital ratio:
This is also known as the current ratio in some spaces. To calculate it, divide the company’s current assets by its current liabilities. This value serves as a reliable indicator of the company’s financial condition. If the value is less than 1.0, it means that the company is likely to encounter problems in the coming months. Its debts are more than the liquid assets can handle.
If the value is between 1.2 and 2.0, it means that the company has a stable cash flow. Simply based on this calculation, assets can comfortably manage liabilities without risking default. Finally, if the value is greater than 2.0, it means the assets are underutilized. This suggests there is room to increase revenue.

Collection rate:
This ratio indicates the efficiency of the way the company manages customer accounts. The ratio can be calculated by multiplying the number of outstanding accounts receivable by the number of days in an accounting period and dividing it by the amount of net credit sales during the same period. If this value is low, it suggests that there is efficient cash flow between customers and the business.

Inventory turnover rate:
This ratio is used to assess whether or not the available inventory is used efficiently. It can be calculated by dividing revenue by inventory cost. Ideally, these values ​​are compared to industry standards to perform accurate working capital management. If the ratio is low, it means there is too much inventory spending. On the other hand, if the ratio is much higher, it suggests that there is not enough inventory, which may be a bottleneck.

Taking these 3 ratios into account is important for effective working capital management. They lend themselves to key asset and liability verticals, giving you a holistic understanding.

Why is this important for entrepreneurs?

There are several reasons why working capital management is important to business owners. On the one hand, it gives a clear understanding of the day-to-day monetary needs of the business. This alone is crucial for growth and for generating optimal business results. Besides that, here are some other reasons why it should matter.

Provides insight into working capital usage

Leads to increased profits

Helps to get better returns on investment

· Improves the liquidity of the company

Maintains production and operation

Identifies ideal financing conditions

Prepares the business for peaks in demand or disruptions

· Improves solvency and credit profile of the company

Gives you an edge over the competition

What are some working capital management best practices?

While the best approaches differ from company to company, few work universally.

1. Ditch the manual collection system:
Adopt electronic transactional systems to optimize invoicing processes. This way, you can take advantage of automated processes to ensure your debts are always on time. Improved cash conversion cycles also give you more room to work.

2. Review your credit terms with debtors:
Reassess contracts with debtors and enforce strict late payments to encourage a healthy culture of getting paid on time. Lack of management in this regard negatively affects cash flow and can be easily resolved with routine credit checks.

3. Avoid storing:
Although inventory is an asset, too much limits cash flow. Phase out slow-moving inventory and optimize processes to increase turnover. Inventory management is the solution and can greatly benefit from e-procurement tools or inventory automation systems.

Besides these practices, working capital management also involves smart financing strategies. Borrowing from the right working capital financing tool is essential to generating profits and staying in the green. For this purpose, Bajaj Finserv working capital loan is a great option to consider. With it, you can capitalize up to Rs.45 lakh to fund business operations and maintain healthy cash flow. This instrument is easy to use and offers disbursement within 24 hours of approval. Additionally, you can opt for the Flexi loan facility to borrow from your sanction based on your business needs and only pay interest on the amount you use. To get started right away, check your pre-approved offer today.

Posted: Thursday, July 29, 2021, 12:50 p.m. IST