What’s working capital in a business? Do you want more cash for your business?
It’s not hard to imagine how a business might paint a rosy picture of itself by tweaking an assumption here or there. However, by managing working capital, you can use financial numbers to help your company improve its actual performance without increasing sales or bringing costs down.
Discover how to manage working capital to improve financial stability.
Managing Working Capital
Berman and Knight explain how to manage working capital—the readily available resources, not theoretical or tied up in long-term debt—by adjusting the timing of how payments are made and carefully controlling inventory levels.
A business’s working capital consists primarily of cash, inventory, and incoming payments, minus short-term liabilities. By effectively managing how it handles capital, your company can free up cash and improve its financial flexibility. Two key metrics that Berman and Knight say to watch are the time it takes to collect on payments, and how long you take to pay your own bills. In general, you want to collect incoming payments as early as possible, while putting off outgoing payments as long as you can without angering your vendors. Doing so maximizes how much cash you have on hand at any moment, even without increasing your sales or bringing down your operating expenses.
(Shortform note: Berman and Knight’s recommendation to “collect early and pay late” is age-old business advice, but there are some advantages to the opposite approach. For instance, Some vendors offer better terms, priority service, discounts for early payment, which can result in cost savings over time. Likewise, offering longer payment terms can attract customers, retain their business, and set you apart from competitors. Your optimal approach will depend on your specific circumstances, industry norms, and your relationships with customers and suppliers.)
Berman and Knight also stress that inventory management is crucial in freeing up cash. While keeping goods and materials in inventory is necessary for many industries, excess inventory ties up cash that could be used elsewhere. The challenge is to maintain enough inventory to satisfy your customers while minimizing the amount of cash it ties up. Managers throughout your company can impact inventory levels, from salespeople placing orders to engineers requesting raw materials, so everyone in the product chain needs to know how they add to or subtract from working capital.
(Shortform note: In a mid-size to large business, Berman and Knight’s advice not to tie up too much cash in inventory applies, but for small businesses, there’s sometimes a risk of being low on inventory just when you need it. In 12 Months to $1 Million, Ryan Daniel Moran says that running out of your product can be disastrous for a startup. It cuts off your revenue, destroys your sales momentum, and loses customer engagement. If your product becomes suddenly popular and your sales go up, you might run out of stock and be unable to fulfill all your orders.)
Berman and Knight conclude that even small improvements in capital and inventory management can result in more cash for your business, so a little financial intelligence can go a long way toward your company’s success.
(Shortform note: The smaller your business, the more important it is to manage your capital well. In Innovation and Entrepreneurship, Peter F. Drucker writes that a lack of robust financial controls can doom even the most promising startups, particularly those that grow too rapidly and can find themselves starved of much-needed funds. Drucker also says that as your business expands, it will outgrow its initial funding method, possibly making you bring in new partners or offer stock to the public. The capital management skills that Berman and Knight suggest you develop can help you estimate your business’s future needs and set them in motion today.)
