As an entrepreneur, managing your business’s finances is high on your list of priorities. However, for many, this process starts and ends at analysing the balance sheet. This is a flawed approach and runs the risk of insolvency as it neglects one crucial element – working capital. This part of the business’s finances has to do with the daily cash flow needs. Enterprises need funds to operate optimally and these operating costs are only available if there is sound working capital management.
Working capital is simply the money that a business needs on a regular basis. It funds short-term needs like material costs, payroll, and a range of other such expenses. Having enough working capital is crucial for stability, as it ensures uninterrupted business operation. To easily know how much of this type of funding 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 business’s liquidity, in the short-term, and indicates how much is available for expenses. Effective working capital management is key to ensuring that there is always enough to sustain business operations. To know more about this concept and to understand its importance to entrepreneurs, read on.
What is the concept of working capital management?
Working capital management is simply the practice of managing assets and liabilities efficiently. It means leveraging both components of working capital to the maximum. This type of monitoring is critical for any business as it helps guarantee cash flow for both debt obligations as well as everyday costs. While the basic overview may be quite simple, working capital management can be complex as you delve deeper.
For one, it relies on 3 key ratios, which are inventory turnover ratio, collection ratio, and working capital ratio. Here is a brief overview of each.
· Working capital ratio:
This is also known as the current ratio in certain spaces. To calculate it, divide the current assets of the company by its current liabilities. This value serves as a viable indicator of the company’s financial standing. If the value is below 1.0, it means that the company is likely to experience problems in the coming months. Its debt obligations are higher than the liquid assets are able to handle.
If the value is between 1.2 and 2.0, this means that the company has stable cash flow. Simply based on this calculation, the assets can comfortably handle the liabilities without risking default. Lastly, if the value is over 2.0 it means that the assets are being underutilised. It suggests that there is room to increase revenue.
· Collection ratio:
This ratio indicates the efficiency of how the company handles the accounts receivables. The ratio can be calculated by multiplying the number of outstanding accounts receivable with the number of days in an accounting period and dividing it by the amount of net credit sales during the same time frame. If this value is low, it suggests that there is efficient cash flow between customers and the company.
· Inventory turnover ratio:
This ratio is used to assess whether or not the inventory on hand is being used efficiently. It can be calculated by dividing revenue by the inventory cost. Ideally, these values are compared with industry standards to carry out accurate working capital management. If the ratio is low, it means that there is too much being spent on inventory. On the other hand, if the ratio is much higher, it suggests that there isn’t enough inventory, which can be a bottleneck.
Accounting for these 3 ratios is important for effective working capital management. They lend themselves to the key verticals of both assets and liabilities, giving you a holistic understanding.
Why is it important to entrepreneurs?
There are several reasons why working capital management is important to business owners. For one, it gives a crystal-clear understanding of the business’s day-to-day monetary requirements. This alone is crucial for growth and to generate optimal results from the venture. Besides this, here are a few other reasons why it should matter.
· Provides insight into the usage of working capital
· Leads to increased profits
· Helps get better returns on capital investment
· Improves the company’s liquidity
· Sustains production and operation
· Identifies ideal financing terms
· Prepares the business for peak demand or disruptions
· Enhances the company’s solvency and credit profile
· Gives you an edge over the competition
What are a few best practices of working capital management?
While the best approaches will differ from company to company, there are few that work universally.
1. Ditch the manual collections system:
Adopt electronic transactional systems to optimise invoicing processes. This way you can leverage automated processes to ensure your payables are always on time. The enhanced cash conversion cycles also give you more legroom to work with.
2. Revisit 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 solved with routine credit checks.
3. Avoid stockpiling:
While inventory is an asset, too much of it restricts cash flow. Phase-out the slow- moving inventory and optimise processes to increase the turnover ratio. 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 key to turning profits and staying in the green. To that end, the Bajaj Finserv Working Capital Loan is an excellent option to consider. With it, you can capital up to Rs.45 lakh to fund business operations and maintain healthy cash flow. This instrument is easy to avail of and offers disbursal within 24 hours of approval. What’s more, you can opt for the Flexi loan facility to borrow from your sanction as per your business needs, and pay interest only on the amount you utilise. To get started right away, check your pre-approved offer today.
