The Fundamentals of Sound Working Capital Management
At its core, working capital management is a corporate strategy designed to ensure a company is operating as efficiently as possible by increasing visibility into its assets and liabilities. By monitoring these factors in a proactive, real-time way, businesses put themselves in a better position to make sure they have the cash flow necessary to meet both debt obligations and short-term operating costs.
What is working capital management?
Working capital, also known as net working capital (NWC), is made up of the difference between a business’s current assets (cash, invoices, etc.), inventory, and current liabilities (e.g. accounts payable). Working capital isn't just a measure of a business's liquidity — it also delivers valuable insight into their operational efficiency and short-term financial health.
If an organization has positive working capital, in theory it has the additional funds necessary to invest back in the business to let it grow and evolve. If the organization has negative working capital, its assets aren't greater than their liabilities, which could lead to issues like paying back debts on time, in the right amount.
Working capital management helps shed light on current standing as early as possible, allowing organizational leaders to protect the functionality and standing of their business. For example: If cash flow is trending in the wrong direction, a working capital management strategy can help identify and address the issue before it becomes a bigger problem, helping avoid limited access to cash that could create a need to sell assets or restructure.
The factors that impact working capital
No two companies are created in quite the same way — the working capital needs of all organizations will naturally differ, meaning there's no one-size-fits-all approach to working capital management. Only by starting with the business itself will you be able to work backwards, putting together a strategy that makes the most sense given the context.
The size of a company, its structure, and its long-term business strategy will all impact working capital needs. That last point is particularly important, as funds will be critical when it comes to capitalizing on opportunities to continue to grow and evolve at the right rate. Without access to the appropriate level of cash flow, organizations may be able to identify opportunities for continued expansion, but they most likely won’t be in a position to take advantage of them.
Other factors for working capital are directly related to decisions a business has made in the past. These can include the types of products or services they're selling (and if their sales volumes fluctuate seasonally or through other means), how competitive the market is, the number of competitors, and even the level of interest rates it’s dealing with.
The essentials of working capital management
What makes working capital management so critical? In a word, it’s balance. It’s a key process that balances business core functions, including:
- Trade receivables
- Trade payables
- Short-term financing
This helps ensure a company has access to the resources it needs to operate as efficiently as it can.
The cash a business has on hand should always be enough to manage the types of needs it hasn’t anticipated. However, if cash on hand is too great, it could underline insufficient spending habits. While organizations always want to have money stored away for an emergency, they also want to be pouring every available dollar back into the business so they can continue to grow.
Debt management (including accounts payable) plays directly into this balance. The goal should always be to become liquid enough to A) maintain ordinary operations without stress, and B) take care of those unexpected needs in an efficient way. Without a plan to address this, the business could be exposed to unnecessary financial risk.
Even credit isn't necessarily as straightforward as one might think. Credit should always be used with an eye towards building healthy business relationships with clients and vendors, but not at the expense of exposing the organization to customers with low credit trustworthiness. That could increase risk tolerance beyond comfortable levels.
Finally, inventory management plays a crucial role, as companies must have enough product to sell to customers. But this plays directly into their inventory of raw materials, too; they should always make sure they have enough on-hand to ramp up production in the event of unexpected peak demand, or at certain times of the year when demand is greater.
If a business doesn't have enough product on-hand, they could easily run into a situation where inventory levels are far too high, meaning they’re paying to store products they can't sell as quickly as they need to. This keeps overhead costs high, impacting cash flow — and, depending on the industry, those products may become obsolete during that time and virtually impossible to sell.
At that point, the organization is wasting resources manufacturing products people don't want, and paying to store inventory that it won't be able to move.
Working capital management helps to avoid these issues by allowing the business to strike that delicate balance between what they need today, and what they need to achieve in the future. At the same time, working capital management is crucial because it allows them to proactively plan for the future.
Let's say an organization wants to launch a new product or expand into a new market. They’ve identified an opportunity without much competition, and need to strike while the iron is hot. Naturally, this is going to require a significant investment — something that will reduce their cash flow. Unless they have a working capital management plan in place, they might not be able to take advantage of that opportunity, leaving the door open for someone else to take it. It's an unenviable position for any business leader to be in.
Best practices of working capital management
While working capital management does take a close look at short-term characteristics of your business, the major benefits it brings with it create long-term success. By making sure that all available resources are used in the most efficient way possible, it helps improve a company's earnings and helps dramatically improve profitability.
One of the biggest best practices for effective working capital management is researching the current stability of a company as well as who their customers are. Unless leaders have a deeper understanding of the company’s key performance metrics and your long-term goals, they won’t be able to put the type of plan in place they need to effectively handle working capital management in the future.
Businesses should always be looking for ways to maximize working capital. Two significant methods to explore are:
- Early pay discounts: Where companies pay suppliers early in exchange for a discount
- Multilateral netting: A payment agreement where payments are summed, rather than settled individually, which provides
They should also include factors like payroll costs, and look at how quickly they pay their vendors and how quickly their customers pay their invoices.
Organizations will also want to explore a more robust Business Spend Management (BSM) platform to better unify their procurement, invoice management, and expense management processes. By streamlining these key efforts into one system, companies are able to gain full-scale visibility into, and control of, their spend and working capital.
A highly flexible system, like Coupa’s Business Spend Management Platform, offers end-to-end BSM capabilities to integrate best-of-breed technology with procurement, finance, and treasury processes. With over 10 million configuration permutations, hundreds of APIs, and workflow-building capabilities, the platform lets organizations design a unique working capital management process that meets their most exacting needs. And with open cloud architecture and a straightforward approach integration, companies can deploy the platform quickly — meaning a faster, safer, and more straightforward way to manage business spend.
But before technology is even on the table, it’s essential for companies to put the right change management processes in place. By doing so they can break down silos, allowing them to unify processes and work smarter together across the organization. Unlocking working capital requires visibility and control from source-to-settle, which is gained from collaboration across teams and access to the right technologies.
Working capital management is a strategic process that addresses efficiency from multiple angles. It helps organizations make sure they have enough cash on hand to cover expenses and your debt, and allows them to greatly minimize the indirect costs of money spent on working capital. For most organizations, it's also a viable way to help maximize their return on long-term asset investments — which may be the most important benefit of all.