5 min read
Working capital is the lifeblood of your business, fueling day-to-day operations and ensuring you can meet your financial obligations. By improving your working capital, you can:
- Improve your cash flow, which is essential for paying suppliers, employees and other expenses on time. This not only helps you avoid costly penalties and maintain good relationships with stakeholders but also ensures that your business runs smoothly.
- Increase cash on hand, so you can take advantage of early pay and volume discounts or liquidity investment options to increase interest income. Over time, you may not need to reach out to your bank for as many loans, lowering your interest costs.
- Better position your business to take advantage of growth opportunities, such as investing in new projects, expanding into new markets or upgrading operations and recovering faster from market disruptions. A strong working capital position can also make your business more attractive to investors and lenders, as it demonstrates your ability to manage your finances effectively.
Working capital formula
Current assets - current liabilities = working capital
Working capital is the difference between your business’s current assets, including cash, inventory and accounts receivable, and liabilities, such as accounts payable and short-term debts.
For example, if a company's balance sheet has $300,000 in current assets and $200,000 in current liabilities, the company's working capital is $100,000.
Challenges to improving working capital
Midsize businesses often face challenges in optimizing working capital, including:
- Complex operations: As businesses grow, operations become more intricate, making it harder to manage working capital efficiently.
- Limited resources: Midsize businesses may lack the resources and expertise to implement sophisticated working capital management strategies.
- Dependence on suppliers and customers: Limited bargaining power with suppliers and customers can hinder efforts to negotiate favorable terms and manage inventory effectively.
- Cash flow volatility: Fluctuations in sales, seasonality and economic conditions can lead to unpredictable cash flows, making it challenging to maintain optimal working capital levels.
- Lack of technology and tools: Midsize businesses may lack access to advanced technology and tools for cash flow forecasting, inventory management and other aspects of working capital management.
- Risk aversion: Some midsize businesses may be hesitant to change existing practices, even if it could lead to improved working capital management, due to a fear of risk. Assessing risk amid the changing economic and technology landscape can incapacitate treasuries due to the large amount of variables to review.
“We see companies building complex technology ecosystems to gain working capital efficiencies because their existing systems can’t accomplish what they need. In building that technology stack, companies must balance making existing technology work through bolt-on technology modules and replacing their outdated systems with the newest technology.”
Michelle Golembieski
Executive Director, Corporate Treasury Consulting at J.P. Morgan
While the challenges can seem overwhelming, they're not insurmountable. A skilled banker or treasury expert can help you effectively navigate obstacles and better implement tactics for improving working capital.
6 practical tactics for improving working capital
- Accelerate accounts receivable: While it may be harder to alter customer behaviors, you can incentivize change by offering early payment discounts or shortening terms. You can also digitize invoices and collections to help you get paid faster. An automated collection process and digitized invoicing can incentivize customers to make payments directly through the portal.
- Tighten accounts payable: You can optimize working capital in accounts payable in several ways, including negotiating favorable payment terms with suppliers, making payables processing more efficient by using electronic workflows, electronic payment methods and taking advantage of early payment discounts.
- Reduce operating costs: You can start by identifying areas where you can reduce costs without compromising quality. Optimizing processes, renegotiating contracts or outsourcing specific functions can help your organization save money and become more efficient while maintaining the integrity of your products and services.
- Improve visibility and controls: Having a line of sight into and understanding your liquidity position is critical. Ensuring you have the best view of your liquidity position reduces risk. To do so, you can develop accurate cash flow forecasts to plan for future cash needs and use inventory management tools to track and forecast demand accurately.
- Measure and manage working capital: Keep your thumb on the pulse of your organization by understanding and monitoring key performance indicators. Managing working capital includes tracking payables and receivables turnover and the current ratio, quick ratio and cash conversion cycle. By staying on top of these metrics, you can easily identify if they deviate from industry norms or historical trends and can react quickly.
- Consider financing options: Effective working capital management can help you decrease your reliance on external capital and better predict when you’ll need it. From there you can consider exploring different investment and financing options, such as lines of credit, term loans or invoice financing to bridge short-term cash-flow gaps.
The bottom line: Implementing working capital optimization strategies can help midsize businesses improve their overall financial performance. While it may seem daunting, small- to midsize businesses have the advantage of less complex cash needs and flatter organizations that enable quick decisions. Capitalizing on these advantages puts midsize businesses in a unique position to implement working capital strategies for the long-term.
JPMorgan Chase Bank, N.A. Member FDIC. Visit jpmorgan.com/commercial-banking/legal-disclaimer for disclosures and disclaimers related to this content.
