Understanding working capital

Sep 22 2021 | PayPal editorial staff | 6 min read

Understanding working capital management is key when it comes to staying on top of your cashflow and deciding when it’s the right time to make investments that will help your business grow. It can also help you prepare for the natural ups and downs of your business.

So what is working capital?

Working capital is a financial term that calculates the difference between your business’s assets and liabilities – it’s what’s leftover. Businesses use it to run their business and pay for everyday expenses, and to invest in new projects and initiatives. But beyond cash in the bank, working capital also includes any assets that can quickly be turned into cash.

There are three types of working capital and each has its own degree of availability.
  1. Cash. A business uses cash to pay its bills, buy inventory and supplies, and pay employees. Cash on hand meets today’s expenses.
  2. Accounts receivable. A receivable is a customer’s unpaid bill. It becomes cash once it’s been paid and settled. Receivables are generally due within 30 – 90 days, depending on the invoicing terms.
  3. Inventory. While inventory can’t be used to pay immediate expenses, it can be sold at a discount to raise cash quickly.

Working capital management 101

1. Managing cash.

The most basic way for a business to manage working capital is to improve cashflow by increasing the amount of cash coming into the business and decreasing the amount going out. It’s basic common sense. Many businesses maintain positive cashflow simply by collecting receivables quickly and slowing down payables (without damaging supplier relationships, of course).

Businesses with long invoice periods or seasonal ups and downs can find managing cashflow more challenging.

Forecast cashflow

To effectively manage working capital, you need a solid understanding of your income and expenses to create a cashflow forecast. When it’s business as usual, you should be able to easily manage and predict what comes in and what goes out. Challenges arise when unexpected costs start to creep into the forecast.

It’s impossible to account for every unexpected cost, but you can start by making a ‘worst-case scenario’ list. That list might include things like replacing a critical piece of equipment, hiring additional staff or purchasing more supplies. While it can be difficult to predict timing, knowing beforehand how much things cost can help your business be more prepared.

Remember, not all costs are associated with disasters or things going wrong. Sometimes growth, new accounts, new clients or new projects put a strain on cashflow because they require upfront investment before seeing a return.

Try to forecast cashflow for an entire financial year. Having a handle on monthly cash positions is a key step in working capital management.

2. Managing receivables.

Establish a receivables policy

Every business should have an accounts receivable policy to help optimise working capital. That policy might include when you send invoices, how much will be billed and when you expect payment.

To develop an effective accounts receivable policy that benefits both your business and your customers, make sure it covers these 4 activities:
  • Customer credit approval. Clearly state how customer credit is evaluated and approved.
  • Collection process. Include the actions you’ll take if you don’t receive payment or have an invoice dispute.
  • Customer data. Determine what customer information to collect.
  • Invoicing and billing. Decide when and how to let your customers know how much they owe.

Collecting payments

If you’re giving customers the option to pay over time, make sure the terms of your invoice are clear. Managing customer payments should be part of any accounts receivable policy. Follow these tips to optimise customer payment processes and strengthen your working capital:
  • Let customers pay over time. Based on the industry and other standard practices in your field, decide if you’ll offer customers the flexibility to pay over time, perhaps through instalments or with an upfront deposit.
  • Make decisions about extending payment terms quickly. Taking a long time to approve or reject an extended payment period can have negative consequences, like slowing down the sales process, frustrating customers and sales staff, and losing sales.
  • Review payment collection processes regularly. Customer growth (or lack thereof), industry changes and economic changes require a review of these processes on a regular basis.

Failure to effectively manage account receivables can cause a trickledown effect, impacting vendor payments and whether they’re willing to offer your business credit.

Managing customer data

Keep customer information in your billing and collections systems. Your customer data should include physical and email addresses, what and how much they can purchase on credit, and whether they receive volume discounts or credits. These tips will help you manage your data effectively:
  • Centralise it. Centralise customer data collection and management.
  • Audit the data. Regularly audit the data for accuracy, paying particular attention to data that reflects unusual credit limits, payment terms or discounts.
  • Build processes. Establish a process for documenting and confirming changes to customer data.
  • Limit access. Ensure only authorised employees can change customer data.
  • Use secure tools. Develop policies and use secure tools to protect customer data security.
Mismanaging customer data can negatively impact receivables, the collection process and, ultimately, your working capital. If you send an invoice to the wrong address, you won’t get paid on time. If your data is incorrectly set to 60 day payment terms instead of an agreed 30, the process to turn receivables into cash slows down.

Managing invoicing and billing

Small businesses often struggle with invoicing and billing. As a result, they don’t know what payments are outstanding and they may double bill or fail to bill customers. To avoid these issues, create a billing process that generates accurate invoices sent in a timely manner. Here are some tips for developing an effective billing process:
  • Automate it. Automation can reduce time and eliminate some, if not all, human error.
  • Use electronic billing systems. Reduce delivery time by emailing invoices to customers.
  • Offer a customer portal. Letting customers place orders, view their account, make payments and initiate enquiries or disputes online can save time and money.

As a small business owner strapped for time, don’t let invoicing fall to the bottom of the priority list. It’s the first step in getting paid for your goods and services, and key when it comes to having working capital on hand. With PayPal Invoicing, you can easily organise, track and manage your full history of invoices online, and send reminders in a click.

3. Managing inventory and supplies.

Inventory and supplies take a great deal of cash to acquire so they can have a significant impact on your working capital but managing them is a balancing act. You need enough inventory and supplies on hand to meet customer demand, but not so much that it negatively affects your working capital.

To maximise working capital, adopt inventory and supply replenishment processes that best fit your business. While these processes will vary from business to business, here are some best practices to consider:
  • Monitor supplier performance. To get the best materials and service, closely track supplier performance and keep detailed records. If a supplier is not delivering as expected, use your records to negotiate better prices or additional rebates and discounts.
  • Use automated and manual calculation processes. An inventory system can automatically alert you when inventory is low, but a person should make final decisions about ordering inventory. Completely automated ordering can put your business in an overstock situation.
  • Prepare demand forecasts. Accurate forecasts can help manage inventory levels. Think about whether goods and services are seasonal, and how quickly your customers expect to receive them.

Close management of inventory and supplies can be very helpful in efforts to optimise working capital.

Stocktaking

Before you can effectively control inventory, you need an accurate count and a plan for handling inventory variances.

Here are some tips for performing stocktakes:
  • Stocktake high-value inventory more frequently. Consider taking a full inventory count at each site once a year. Identify your high-value inventory and check the count more frequently.
  • Manage obsolete inventory. Stocktakes help you identify inventory that’s moving slowly or becoming obsolete. Once identified, get rid of this inventory through sales, special deals to preferred customers, supplier returns or by donating it.
  • Detail stocktake processes. To ensure efficient and accurate inventory counts, try:
    • Developing and following clear instructions, including what needs to be counted.
    • Using pre-numbered inventory count sheets.
    • Organising products to avoid double counting.
    • Creating a process to avoid counting inventory sold but not yet delivered.

You’re likely to see a difference between your records and your physical counts. Look into any significant differences or repeated variances in the same type of inventory. Conducting regular stocktakes can help you become more aware of potential issues when it comes to inventory and working capital.

Filling working capital gaps

If you’re facing a cashflow gap, or need more to invest in growth or opportunity, a business loan can help. Check out PayPal Working Capital for more information.
 
The contents of this site are provided for informational purposes only and are solely our opinions. The information in this article does not constitute legal, financial, business or investment advice of any kind and is not a substitute for any professional advice. You should always obtain independent, professional accounting, financial, and legal advice before making any business decision.
The contents of this site are provided for informational purposes only. The information in this article does not constitute legal, financial, IT, business or investment advice of any kind and is not a substitute for any professional advice. You should always obtain independent, professional accounting, financial, IT and legal advice before making any business decision.