As a business owner, you know that working capital is linked to your company’s financial health, but to what extent? Understanding how working capital affects day-to-day operations, influences cash flow, and impacts your overall financial stability is crucial to your business’s success. Fortunately, you are in the right place. This is your guide to everything you need to know about working capital management and cash flow.

What Is Working Capital?

In its simplest terms, working capital is the money your business has on hand that is not allocated to meet immediate financial obligations.

The following is the equation for calculating working capital:
Current Assets – Current Liabilities = Working Capital

Current assets are either cash or valuables such as inventory or accounts receivable that you can easily turn into cash to meet short-term financial obligations. On the other hand, current liabilities are financial obligations your business must meet in the near future. Examples include payroll, short-term loans, and accounts payable.

Working Capital Plays 4 Main Roles in Your Business

Before we talk about how working capital affects cash flow, it is important to understand the 4 main roles working capital plays in your business.

1. Cash Flow Management

Having money on hand at all times ensures your business can pay its bills, purchase inventory, and cover additional operating expenses without relying on financing or disrupting service to your customers.

2. Efficient Operation

With sufficient cash on hand, your business can operate more efficiently. You can negotiate better terms with vendors, buy in bulk, and take advantage of early payment discounts.

3. Growth and Expansion

Have the flexibility to invest in growth opportunities, such as expanding service offerings or upgrading suppliers.

4. Financial Cushion

It is always good to have a little wiggle room to face downturns or unexpected challenges, such as unforeseen expenses or a sudden drop in sales. Working capital provides a financial buffer that will allow your business to navigate challenging periods.

How Does Working Capital Affect Cash Flow?

Working capital directly impacts your business’s cash flow. Understanding this relationship is key to managing financial health. Let’s take a closer look at how working capital affects cash flow.

Influences Liquidity

Liquidity is how quickly you can convert your business assets into cash. The amount of working capital your business has on hand greatly influences your business’s liquidity. Having strong liquidity means the company can meet its financial obligations in a timely manner. On the other hand, inadequate working capital can lead to cash shortages, forcing your business to take on debt, which can be an extremely slippery slope.

Cash Conversion Cycle

The cash conversion cycle is the amount of time it takes your business to convert non-cash assets, such as inventory and accounts receivable, into cash flow. If your business has too much inventory that doesn’t sell or can’t collect payments due, your working capital is reduced, which has a negative effect on cash flow. You need sufficient working capital so that the cash conversion cycle is not interrupted.

Balancing Cash Flow

Working capital management is crucial to balancing cash flow. If your business pays on accounts too aggressively, then you may deplete your working capital and find yourself strapped for cash. On the other hand, if you delay paying vendors, it can hurt your relationship with suppliers, and you may incur penalties and fines. Managing your cash flow is a careful balancing act.

Seasonal Fluctuations

Many businesses experience seasonal fluctuations in sales, which can lead to changes in working capital needs. For instance, if you are in retail, your business may need more inventory before a holiday season. This means increasing current assets and requiring more cash outflow. Understanding these patterns allows a company to plan its working capital needs effectively, ensuring that cash flow remains steady throughout the year.

Working Capital Management for Optimal Cash Flow Best Practices

Maintaining healthy cash flow requires effectively managing your company’s working capital. The tips below are effective business working strategies.

Optimal Inventory Management

The last thing you want to do is overstock inventory, have to pay for additional storage costs, and reduce your working capital. Use the most recent data, analytics, and financial reports to keep optimal levels of inventory on hand at all times. A trusted financial partner can help you determine whether too much of your working capital is tied up in inventory.

Timely Closeout Account Receivables

Invest in a robust account receivables management program to encourage customers to pay their accounts faster. Many companies offer net 60 or net 90 payment terms. If appropriate, consider reducing this to 15 or 30 days. Your business may also offer discounts for early payment. Furthermore, be sure to follow up on overdue invoices until they are paid in full.

Account Payable Extensions

If possible, negotiate extensions or longer payment terms with your vendors to increase your working capital and balance cash flow. When negotiating payment terms, be careful not to damage relationships with your suppliers.

Let Your Trusted Financial Partner Help

No matter the size of your business, working capital significantly impacts your cash flow. By understanding working capital management, your business can ensure cash flow optimization, which leads to long-term profitability.

enTune is here to help you every step of the way. As the number one financial partner in the United States, our team has the experience and knowledge to help you secure your business’s financial future. Free up time to focus on running your business and let us worry about your financial security. Do not waste another minute worrying about your company’s financial future. Contact enTune today to schedule your complimentary consultation. We look forward to working with you!