What Is the Purpose of Working Capital

Working capital management – defined as current assets minus current liabilities – is a business tool that helps companies effectively make use of current assets and maintain sufficient cash flow to meet short-term goals and obligations. By effectively managing working capital, companies can free up cash that would otherwise be trapped on their balance sheets. As a result, they may be able to reduce the need for external borrowing, expand their businesses, fund mergers or acquisitions, or invest in R&D.

Working capital is essential to the health of every business, but managing it effectively is something of a balancing act. Companies need to have enough cash available to cover both planned and unexpected costs, while also making the best use of the funds available. This is achieved by the effective management of accounts payable, accounts receivable, inventory, and cash.

Working capital formula

Working capital is calculated by subtracting current liabilities from current assets. That means that the working capital formula can be illustrated as:

Working capital = current assets – current liabilities

Current assets include assets such as cash and accounts receivable, and current liabilities include accounts payable.

Other important working capital metrics include:

• Days Sales Outstanding (DSO) – the average number of days taken for the company's customers to pay their invoices.
• Days Payables Outstanding (DPO) – the average number of days that the company takes to pay its suppliers.
• Days Inventory Outstanding (DIO) – the average number of days that the company takes to sell its inventory.
• Cash Conversion Cycle (CCC) – the average time taken for the company to convert its investment in inventory into cash.

CCC is calculated as follows:

CCC = DIO + DSO – DPO

The shorter a company's CCC, the sooner it is converting cash into inventory and then back to cash. Companies can reduce their cash conversion cycle in three ways: by asking customers to pay faster (reducing DSO), extending payment terms to suppliers (increasing DPO) or reducing the time that inventory is held (reducing DIO).

Objectives of working capital management

Working capital is an essential metric for businesses to pay attention to, as it represents the amount of capital they have on hand to make payments, cover unexpected costs, and ensure business runs as usual. However, working capital management isn't that simple, and there can be multiple objectives of a working capital management program, including:

• Meeting obligations. Working capital management should always ensure that the business has enough liquidity to meet its short-term obligations, often by collecting payment from customers sooner or by extending supplier payment terms. Unexpected costs can also be considered obligations, so these need to be factored into the approach to working capital management, too.
• Growing the business. With that said, it's also important to use your short-term assets effectively, whether that means supporting global expansion or investing in R&D. If your company's assets are tied up in inventory or accounts payable, the business may not be as profitable as it could be. In other words, too cautious an approach to working capital management is suboptimal.
• Optimizing capital performance. Another working capital management objective is to optimize the efficiency of capital usage – whether by minimizing capital costs or maximizing capital returns. The former can be achieved by reclaiming capital that is currently tied up to reduce the need for borrowing, while the latter involves ensuring the ROI of spare capital outweighs the average cost of financing it.

Effective working capital management

Speeding up the CCC can improve a company's working capital position, but it may also have other consequences. For example, there is a risk that reducing inventory levels could negatively impact your ability to fulfil orders.

Where DPO is concerned, your accounts payable is also your suppliers' accounts receivable – so if you pay suppliers later, you may be improving your own working capital at the expense of your suppliers' working capital. This may have an adverse effect on your relationships with suppliers and could even make it difficult for cash-strapped suppliers to fulfil your orders on time.

Effective working capital management therefore means taking steps to improve the company's working capital position without triggering adverse consequences elsewhere in your supply chain. This might include reducing DSO by putting in place more efficient invoicing processes, so that customers receive your invoices sooner. Or it might mean adopting an early payment program that enables your suppliers to receive payment sooner than they would otherwise.

Working capital management solutions

Companies can use a wide range of solutions to support effective working capital management, both for themselves and for their suppliers. These include:

• Electronic invoicing. Electronic invoice submission can help companies achieve working capital benefits. By streamlining the invoicing process, you can reduce the risk of errors, automate manual processes, and make sure that your customers receive your invoices as early as possible – which may ultimately mean you get paid sooner. Electronic invoice submission methods can enable companies to turn purchase orders into invoices automatically or submit high volumes of invoices using system-to-system integration.
• Cash flow forecasting. By forecasting future cash flows – such as payables and receivables – companies can plan for any upcoming cash gaps and make better use of any surpluses. The more accurately you can predict your future cash flows, the better-informed your working capital management decisions will be.
• Supply chain finance. For buyers, supply chain finance – also known as reverse factoring – is a way of offering suppliers early payment via one or more third-party funders. Suppliers can improve their DSO by getting paid sooner at a low cost of funding – while buyers can preserve their own working capital by paying in line with agreed payment terms.
• Dynamic discounting. Dynamic discounting is another solution that buyers can use to provide early payment to suppliers – but this time there's no external funder, as the program is funded by the buyer via early payment discounts. Like supply chain finance, this enables suppliers to reduce their DSO. What's more, it allows buyers to achieve an attractive risk-free return on their excess cash.
• Flexible funding. Last but not least, working capital providers that offer flexible funding may allow buyers to move seamlessly between supply chain finance and dynamic discounting models, meaning companies can adapt to their varying working capital needs while continuing to support their suppliers.

What Is the Purpose of Working Capital

Source: https://taulia.com/glossary/what-is-working-capital-management/

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