Working Capital - Why So Important For Business? How to Improve?

Working capital is the money your business needs to operate day to day. It is calculated as current assets less current liabilities - essentially the cash you have left after deducting money going out from money coming in.

Worryingly, a 2022 report by Accenture (with the support of Xero) found that 9 out of 10 small UK businesses were undermined by cash flow challenges. Another Xero study found that 55% of large organisations admitted to paying small business suppliers later than agreed, with 78% of this number claiming to be aware of the poor impact this could have on their suppliers' business.

Careful inventory management can be essential to strong working capital

Objectives of working capital management

The first objective is liquidity - being able to meet debts as they fall due. Late payments can result in lost employee loyalty, lost supplier discounts, and a damaged credit rating.

The second objective is profitability - achieving the return on investment expected by investors.

However, there is usually a trade-off between liquidity and profitability as more liquid assets (such as cash) tend to generate lower returns than less liquid assets (such as long-term investments).

Use of ratios

Current ratio (or working capital ratio) = Current assets / Current liabilities

The current ratio helps to determine liquidity. A ratio below 1 is an indication of financial difficulties as it suggests there is not enough assets (usually cash) to meet short-term debts.

The optimal liquidity level varies depending upon industry and type of business but a general rule of thumb is to maintain a current ratio of between 1.5 to 2.

If a business has slow-moving inventory the quick ratio may give a more reliable measure:

Quick ratio (or acid test) = (Current assets less Inventory) / Current liabilities

Cash operating cycle

The cash operating cycle - also know as working capital cycle - is the number of days between paying suppliers and receiving cash from sales and is calculated as:

Cash operating cycle = Inventory days + Receivable days - Payables days

A longer cycle suggests there are more resources tied-up in working capital. Therefore, it is often desirable to have a shorter cycle.

Tips to better manage your working capital

1. Maintain an accurate cash flow forecast - this will help you to be better prepared in advance, leading to better decision making.
   

2. Reduce your debtor days - encourage or incentivise customers to pay you sooner.
   

3. Increase your creditor days - negotiate longer terms with suppliers where possible.
   

4. Manage inventory more efficiently - balance having enough inventory to fulfil orders without unnecessarily high levels of inventory that increase storage costs or creates obsolete stock.

Points to note:

This document is a simplified helpsheet and careful research should be completed if you are unsure.

Serious cash flow problems may require a business to consider administration or insolvency.

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