The heart of any business revolves around working capital. With ease, the business is able to conduct its day to day operations, such as paying salaries, buying inventory, or covering short-term bills. Even if profits seem good on paper, a business may experience cash flow problems if it fails to manage its working capital well.
Our discussion of this blog will revolve around the definition of working capital, its significance, and how to effectively manage it using an inventory example.
What Is Working Capital?
The amount obtained by subtracting current liabilities from current assets is working capital. Cash, accounts receivable, and inventory are all current assets, while accounts payable, short-term loans, and other liabilities payable within one year are also current assets. Working capital is calculated using the following formula:
Working capital = Current assets - Current liabilities
Acknowledge through simple language.
Example:
The formula will provide you with your working capital if your business has current assets of ₹10 lakh and current liabilities of ₹6 lakh.
Working capital = ₹10 lakh - ₹6 lakh = ₹4 lakh
This ₹4 lakh is what you have left to run your business smoothly.
Why Is Working Capital Important?
1. Maintains a smooth flow of cash:
By properly managing working capital, it is possible to always have enough cash available to meet business needs.
2. Makes certain that suppliers and employees receive timely payments:
When your working capital is managed well, you can ensure timely payments to your vendors, suppliers, and employees.
3. Provides support for swift decision-making:
Having sufficient liquidity ensures that you can act quickly on new business opportunities, like bulk purchases or sudden demand, without delay.
4.Eliminates the need for short-term borrowing:
Your interest costs and financial risk will be reduced due to the sufficient working capital, which will not require you to rely heavily on short-term loans or lines of credit to cover operational expenses.
Working capital consists of the following components:
1. Cash and bank balances
2. Customer Receivables (debtors)
3. Inventory (stock)
4. Trade Payables (creditors)
Our focus today will be on inventory, which is an essential component of working capital management.
Inventory and Its Impact on Working Capital
- Having too much inventory in a business can lead to cash crunches, and having too little inventory can lead to a decline in sales. Maintaining a proper balance is the most important thing.
- Imagine a retail store owner purchases ₹5 lakh worth of goods every month to maintain stock across various categories. On average, ₹3 lakh worth of goods are always unsold and are languishing in storage.
- Over time, the store realises that certain items, especially seasonal or trend-driven products, are not selling as expected. They end up lying on the shelves or in the warehouse for months. This creates several problems:
- ₹3 lakh of cash is tied up in stock that does not generate revenue.
- Storage costs increase due to the need for more space and handling.
- Some items become obsolete or expire, causing losses.
- Eventually, the business starts to feel the strain on its daily cash requirements, even though the store appears to be fully stocked.
How Smart Businesses Manage Working Capital
Here are some proven techniques:
1. Pay receivables quickly.
The faster a business pays, the better its cash position. That’s why invoices are sent out immediately after a sale is made. Some businesses even offer small discounts to customers who pay early, which is an easy way to keep the money flowing.
2. Delay payments (but don’t damage relationships).
Most suppliers offer credit periods and using that entire window wisely can free up working capital. But this only works smoothly when there is mutual trust and open communication. In many cases, a strong relationship with suppliers can also open the door to better payment terms. However, the important thing is not to push things so far that it damages trust or disrupts supply.
3. Manage inventory efficiently
Money is stuck in the till if inventory is sitting idle. Businesses that monitor stock levels and keep track of how quickly items are moving can prevent overstocking. Some use ABC analysis, which categorises items as A - high value, B - medium, and C - low. This prevents unnecessary bulk purchases.
4. Monitor cash flow weekly.
A lot can change in a business in a matter of days. Weekly cash flow monitoring makes it easy to spot shortfalls. Some people also keep a small cash reserve that can be used immediately.
5. Avoid unnecessary short-term loans until they are paid off.
Short-term credit can be paid off quickly, often at a higher cost. It carries higher interest rates. That's why many businesses monitor their available cash before turning to outside funding.
Real-Words Insight
A small electronics company used to have ₹12 lakhs in stock at any given time, which would last for four months. This made the owner feel "safe" and prepared. But as time passed, new models were released, and the price of outmoded goods dropped.
As a result, stock worth roughly ₹3 lakhs became outdated and difficult to sell.
Afterwards, the store upgraded its inventory control system. Only short-term inventory, or enough to cover one and a half months' worth of sales, was kept on hand. Because of this change, they were able to lower storage costs, free up working capital, and increase their monthly profit by 15%.
Conclusion
Making smart decisions every day is just as important to effective working capital management as doing the maths. Your cash flow is affected by everything you do, including payments and inventory. If you stay organised and watchful, you can unlock growth without taking out more loans.
Are you worried about your company's working capital? Put it in a comment!
0 Comments