The ability to cover operating costs, such as payroll, rent, and costs of goods sold (COGS) is critical to any small business.
With effective working capital management, you have a good chance of consistently covering those costs.
Below, you’ll learn:
- What working capital management is
- Why it’s important to manage working capital
- How to quantify your working capital management
- How to improve your working capital management
Let’s get started.
Definition of Working Capital Management
Working capital management is the process of efficiently monitoring and using current assets (e.g., cash, accounts receivable, and inventory) and current liabilities (e.g., accounts payable, payroll due, and short-term debts).
RELATED: What is Working Capital?
Why is it Important to Manage Working Capital?
It’s important to manage working capital because you need cash to pay current liabilities when they come due.
For example, you have a bridal store with these current liabilities at the moment:
- Short-term debts – $35,000
- Accounts payable (wedding gowns from suppliers) – $20,000
- Payroll due – $20,000
Your current assets include cash ($30,000), accounts receivable ($20,000), and inventory ($40,000).
This means your working capital is $90,000 (current assets) minus $75,000 (current liabilities) = $15,000.
In this case, your small business is in a precarious position for two reasons:
- Cash accounts for only one-third of your current assets.
- You only have $1.20 in current assets for every $1 in current liabilities.
To satisfy your short-term financial obligations, you would likely need to convert a large percentage of your accounts receivable/inventory into cash. This might mean offering heavy discounts or getting working capital financing.
If you effectively manage your working capital, you are unlikely to regularly find yourself in the above situation.
How to Quantify Your Working Capital Management
Let’s look at four metrics to quantify your working capital management.
Working Capital Ratio
Your working capital ratio – or current ratio – is current assets divided by current liabilities.
Let’s go back to the bridal store example: the owner has $1.20 in current assets for every $1 in current liabilities. So, the working capital ratio is 1.20.
A working capital ratio of one or higher means a small business has enough current assets to cover its current liabilities.
A working capital ratio of less than one, on the other hand, means a small business owner may be unable to cover short-term financial obligations. In this case, the small business owner has negative working capital.
Typically, a working capital ratio of between 1.5 and 2 is good for a small business.
Working Capital Turnover
Working capital turnover is net annual sales divided by average working capital. To get a useful output, you need positive working capital.
Essentially, working capital turnover shows the short-term financial resources required to support sales – the higher the turnover, the more sales a company can “squeeze” out of every dollar of working capital.
A high working capital turnover is usually a plus for a small business – as long as there is enough working capital to meet short-term financial obligations.
The healthy working capital turnover varies from small business to small business, depending on industry.
The quick ratio – aka the acid test ratio – is somewhat similar to the aforementioned working capital ratio, but with a key difference: only the most liquid assets are included in the current assets part of the equation.
Here’s how the quick ratio is calculated:
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
You may have noticed that inventory is excluded. For most small businesses, it’s difficult to quickly turn inventory into cash – without offering a sizable discount.
So, if you are heavily relying on your inventory to cover your current liabilities, your small business is on shaky ground – unless you have a track record of quickly turning your inventory into cash.
With that in mind, a quick ratio of above one is a sign of a healthy small business – this means you can cover your current liabilities with your most liquid assets.
In the bridal store example, the quick ratio is .67. This is much lower than the working capital ratio of 1.20 because inventory is 44% of the current assets.
The cash ratio goes a step further than the quick ratio, only counting cash and cash equivalents in the numerator.
Here’s how the cash ratio is calculated:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
The cash ratio shows a small business’s ability to withstand a recession or industry slowdown, when accounts receivable might not be collected on time and inventory might not be sold.
The ideal cash ratio depends on your industry and expectations.
In normal times, you might not want a cash ratio of one or higher – particularly if you are confident in your small business’s ability to cover short-term financial obligations with accounts receivable and inventory. Instead, you can take the excess cash and invest in attractive business opportunities.
How to Improve Your Working Capital Management
To improve your working capital management, start by calculating your working capital ratio, working capital turnover, quick ratio, and cash ratio.
At this point, you should have a good idea of your strengths and weaknesses.
Let’s say you have a good working capital ratio and working capital turnover, but your quick ratio and cash ratio are both on the lower end. In this case, you might want to increase your cash on hand – perhaps by shortening your payment terms with customers.
Or maybe your working capital ratio is below one… but you expect sales to significantly increase over the next three years. In this example, you might want to explore long-term financing options.
Overall, effective working capital management comes down to identifying problem areas and finding solutions.
We can’t review every possibility in this article, so if you need help with working capital management, we at Gravity Payments are happy to help – give us a call at 866-701-4700.
The Bottom Line
Your working capital management decisions have a big impact on your small business.
Selling inventory at a massive discount or searching for financing at the last minute are two possible results of poor working capital management strategy.
With effective working capital management, on the other hand, you are less likely to have trouble paying the bills – which means less stress in your day-to-day life.
But what if you need financing to cover your current liabilities for a period of time?
In that case, consider Gravity Capital.
We offer flexible repayment options, reasonable rates, and fast funding.
Learn more about our working capital program.