What is working capital and what does it mean for your business?

May 31 2019 | PayPal editorial staff

Feel like you need a better handle on working capital, what it is, and how you can manage it in your business? We’ve put together this guide to answer your most pressing working capital questions.

What is working capital?

Working capital is a financial term that calculates the difference between your business's assets and liabilities. Working capital is what's leftover. Businesses use working capital to run their business and pay for everyday expenses as well as invest in new projects and initiatives. But beyond cash in the bank, the definition of working capital also includes any assets that can quickly be turned into cash. This article covers three types of working capital. Each has its own degree of immediate availability.
  1. Cash: A business uses cash to pay its bills, buy inventory and supplies, and pay its employees. Cash on hand meets today’s expenses.
  2. Accounts receivable: A receivable is a customer’s unpaid bill. The receivable becomes cash once a customer settles it. 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 discounted price to raise cash quickly.

What does working capital mean for your business?

Understanding working capital management is key when it comes to staying on top of cash flow 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. If your business is considering an opportunity and you don't have the working on capital on hand, there are short-term financing solutions that can help your business bridge cash flow gaps.

Working capital management 101.

1. Managing cash.

The most basic way for a business to manage working capital is to improve cash flow by increasing the amount of cash coming into the business and decreasing the amount going out. Many businesses maintain positive cash flow simply by collecting receivables quickly and slowing down payables without damaging supplier relationships. But businesses that have long invoice periods or seasonal ups and downs can find managing cash flow more challenging.

Forecast cash flow.

To effectively manage working capital, you need a solid understanding of income and expenses to create a cash flow forecast. As long as it’s business as usual, most businesses are able to 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. Items on this list might include replacing a critical piece of equipment, hiring additional staff, or purchasing more supplies. While it may be difficult to predict timing, knowing upfront how much items cost can help your business be more prepared.

Plus, not all costs are associated with disasters or things going wrong. Sometimes growth, new accounts, new clients, or new projects put a strain on cash flow because they require upfront investment before seeing a return. Plan to forecast cash flow for an entire fiscal year. Having a handle on monthly cash positions is a key step in working capital management. If facing a cash flow gap, consider looking into business financing options. PayPal has two business loan options* that may be able to help you manage working capital.

2. Receivables are cash on its way.

Establish a receivables policy.

Every business should have an accounts-receivable policy to help optimize working capital. That policy might include when you send out invoices, how much will be billed, and when you expect payment. To develop an effective accounts-receivable policy that benefits your business and your customers, make sure it covers these four activities:
  • Customer credit approval: clearly state how customer credit is evaluated and approved
  • Collection process: include what 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 how and when to let your customers know how much they owe

Collecting payments from customers.

When giving customers the option to pay over time, make sure the terms of the invoice are clear. Managing customer payments should be part of any accounts-receivable policy. Follow these tips to optimize customer payment processes and strengthen your working capital:
  • Give customers the option to pay over time. Based on industry and other standard practices in your field, decide if you’ll offer customers the flexibility to pay over time. With PayPal Credit,1 you can offer financing to your customers at checkout so they can buy what they want now and pay over time. While your customers get to pay over time, you get paid in full, upfront, with no additional risk.
  • Make decisions about extending payment terms in a timely manner. Taking a long time to approve or reject an extended payment period may have negative consequences. It can slow down the sales process, frustrating both customers and sales staff, and it may result in lost sales.
  • Review payment collection processes regularly. Customer growth (or lack of), industry changes, and economic changes require a review of these processes on a regular basis.
Failure to effectively manage accounts receivable can cause a trickledown effect, impacting vendor payments and whether they’re willing to offer your business credit.

Managing customer data.

After you’ve negotiated payment terms with your customers and suppliers, the work isn’t done. You’ll need to enter their information into a billing and collections systems. Customer data should include physical and email addresses, what and how much the customer may purchase on credit, and whether the customer receives volume discounts or credits. Here are several tips for managing customer data effectively:
  • Centralize data collection and management.
  • Regularly audit data for accuracy and verify data that reflects unusual credit limits, payment terms, or discounts.
  • Have a process for documenting and confirming changes to customer data.
  • Ensure only authorized employees have the ability to change customer data.
  • Have the proper policies and tools in place 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 incorrect address, you won’t get paid on time. If your data is incorrectly set to payment terms at 60 days instead of the agreed upon 30 days, the process to turn receivables into cash slows down. 

Managing invoicing and billing.
Small and medium sized businesses often struggle with invoicing and billing. As a result, they don’t know what payments are outstanding or may double bill or fail to bill customers. To avoid these issues, create a billing process that generates accurate invoices sent on a timely basis. 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 sending invoices to customers electronically.
  • Offer a customer portal. Allowing customers to place orders, view their account, make payments, and initiate inquiries or disputes online may save time and money.
As a 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, easily organize, track, and manage a complete history of each invoice online. You can also send out reminders on unpaid invoices. Customize your invoices with templates for all types of businesses. It’s free to send invoices with a PayPal Business account.

3. Inventory and supplies: An overlooked asset.

Controlling 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. 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 maximize working capital, adopt inventory and supply replenishment processes that best fit your business. Although processes will vary from business to business, here are 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; however, a person should make final decisions about ordering inventory. Automated ordering may 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 optimize working capital.

Counting inventory.

Before you can effectively control inventory, you need an accurate count. Also, a make a plan for handling inventory variances. Here are some tips for performing inventory counts:
  • Count high-value inventory more frequently. Consider taking a full inventory count at each site once a year. Identify your high-value inventory and count more frequently.
  • Manage obsolete inventory. Inventory counts will 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, scrapping, or donating it.
  • Improve inventory count efficiency and accuracy. For efficient and accurate inventory counts, try  the following:
    • Provide clear instructions, including what needs to be counted.
    • Provide pre-numbered inventory count sheets.
    • Arrange products to avoid double counting.
    • Create 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 inventory counts can help you become more aware of potential issues when it comes to inventory and working capital.

The importance of working capital.

Working capital management is a key component of keeping your business healthy. Effective management requires understanding all three types of working capital, not just your cash on hand. That means quickly collecting on accounts receivables, controlling inventory, and improving cash flow forecasting. Doing so can help position your business to handle both growth and downturns.
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. 

1PayPal Credit is subject to consumer credit approval.
*The lender for PayPal Business Loan and PayPal Working Capital is WebBank, Member FDIC. 

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