The Importance of a Working Capital Plan

Working capital is the lifeblood of a business. That’s why an effective working capital plan can help you free up more cash, increase your financial stability and potentially increase your profits. But business owners sometimes skip this type of planning because they don’t know what to look for on their financial statements. Read on to find out what it means to build a working capital plan and how to add one to your routine.

What is working capital?

Working capital is the amount of resources your business has to cover your upcoming expenses. It’s the difference between your short-term assets and your short-term liabilities. Short-term assets are cash, along with other assets that you expect to turn into cash within a year, like unpaid invoices (accounts receivable), inventory and marketable securities.

Short-term liabilities are any bills and other financial obligations that you’ll need to cover within the next year. Your balance sheet should list both categories. The difference between the two is your working capital.

For example, if a small business has $1 million in cash, inventory and unpaid accounts receivables with $750,000 in current liabilities, their working capital is $250,000 ($1 million - $750,000).

What is a working capital plan?

A working capital plan looks for opportunities to either increase your short-term assets and/or reduce your liabilities. This can help put your business in a stronger financial position with more resources.

Another part of a working capital plan is to watch out for swings in the working capital cycle, especially the times when you may not have enough in liquid assets to cover your expenses. That way you can start tapping into other resources to get through the cycle, like taking out a loan or bringing on investors.

The benefits of a working capital plan may include:

• More positive cash flow, from increasing your assets and decreasing liabilities
• Less financial stress due to having more cash and liquidity to deal with swings
• A better credit score from having money on hand to keep up with your bills
• Fewer production delays, as you stay on good terms with your suppliers by paying them on time
• A more valuable company, as more working capital helps give your company the resources to grow, generate higher profits and expand

Strategies to Improve Your Working Capital

With the big picture in mind, here are a few common strategies that can help improve your working capital position.

Speed Up Collection for Accounts Receivable

The longer it takes for your business to get paid, the less cash you have on-hand. Plus, it increases the chance that a customer doesn’t pay at all, which is even worse for your working capital. To avoid trouble, set clear terms with clients for when you expect to get paid, consider scheduling earlier payment deadlines and follow up with clients that are behind on their invoices.

Reduce Accounts Payable

Whether it’s negotiating for improved terms with creditors, paying early to qualify for supplier discounts or just constantly searching for better vendors, anything you can do to reduce the amount owed for accounts payable will help your working capital.

Refinance Debt to Better Terms

If you’ve got outstanding debt and the monthly payments are a strain on your budget, refinancing could buy you some breathing room. This means replacing your current bills with another loan, at better terms. If your credit score and business income have improved since you first took out these loans, you’re in a good position to potentially qualify for a lower interest rate and lower payments.

Avoid Stockpiling Unnecessary Inventory

Even though inventory is technically a short-term asset, it’s not one you can immediately turn into cash during an emergency. That’s why you should avoid holding unnecessary stores of unsold inventory. An inventory management system could help you do that.

Maintain Financing Options

Sometimes working capital swings can still catch you off-guard. Having a business line of credit and/or credit cards available can help you manage your expenses during tight working capital stretches.

A working capital plan looks for opportunities to either increase your short-term assets and/or reduce your liabilities. This can help put your business in a stronger financial position with more resources.

Managing Your Working Capital Plan

Even though there are many benefits to a working capital plan, it’s something that business owners might not develop as they focus on more obvious signs of their financial performance, like their profits and cash flow. This is your chance to get an edge by digging a little deeper into your balance sheet.

First, check what direction your working capital position is moving. Is it increasing or decreasing? Then, try to figure out what caused the change. If you’re losing working capital, is it intentional, like because you spent cash to buy new equipment? Or are sales falling and you need to tighten up expenses?

On the other hand, if you’re building working capital, that’s usually a good sign. But once again you want to figure out the root cause—like whether you built that extra cash from better operations or from a one-time infusion of funds from an outside investor. As you go over your working capital trends, look for opportunities to use the strategies mentioned earlier to help improve your current asset and liability positions.

It’s a good review to conduct regularly, once a month or quarter, along with a cash-flow statement analysis. This planning can help you better understand the financial health of your business and generate more working capital for the future.

Photo: Getty Images

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