How to Manage Working Capital for Long-Term Success

The working capital formula and the working capital ratio are both elements that show your business’s ability to cover its near-term financial obligations (due within 1 year) and still operate. And they’re both easy to calculate.

• Working Capital Formula = Current Assets – Current Liabilities. A positive number shows how much your business has left over after you pay off all current liabilities (due within 1 year).
• Working Capital Ratio = Current Assets / Current Liabilities. A ratio over 1 shows you have enough assets to cover current obligations.

You can use either the working capital formula or the ratio to make short-term decisions that help drive your long-term strategic goals, including timing terms with vendors and customers. By using these figures to prepare, you’ll rarely have to pay expenses out of pocket or factor receivables at a slight discount. Also, you’ll be able to know how much of your on-hand cash you can use for long-term investments.

If you’re ready to learn how to apply this to your business, we’re here to help. Below is a table showing some of the components of working capital that you’ll find on your balance sheet. After the table, you’ll find examples of how to use working capital assets and liabilities to make strategic decisions in real-life situations in order to support long-term business success.

Current Assets	Current Liabilities
●     Cash ●     Short-term investments ●     Inventories ●     Accounts receivable	●     Accounts payable ●     Short-term debt ●     Current portion of long-term debt ●     Accrued liabilities

By negotiating longer payment terms with vendors, compared to those you allow for customers, you can potentially create an interest-free working capital loan. This is because you turn over your accounts receivable faster than your accounts payable.

Imagine you’re in the t-shirt manufacturing space and purchase raw materials so you can sell the completed shirts to retailers and wholesalers for profit. Cotton is a commodity (also thread, etc) and you haven’t selected a vendor just yet. In this space, there are tons of vendors that you can compare and you ultimately negotiate one vendor to net 45 payment terms (45 days after receiving an invoice).

In this example, your shirts are in high demand, so you can require net 30 from your customers. By doing this, you create a 15-day interest free loan where you keep the money your customers pay for 15 days before you have to send it to the vendor.

While 15 days doesn’t sound like a ton of time, doing this over and over adds up. By the end of the year, you’ll sell 12 batches of t-shirts but only pay for 8. Now those 15 days are a big deal.

The vendors still need to be paid, but you can use the cash flow in other ways for your business, including investing in advertising so that next year you sell 24 batches but only pay for 16. If this advertising strategy works and can be expanded, you could sell 48 and pay for 32.

Vendors may give you a discount for paying quickly or charge a fee for paying late. But what if you ignored these because you could get a higher return by using that capital elsewhere?

Imagine this situation where you want to test a pop-up store to sell your shirts directly to consumers:

• You owe $1,000 to vendors for inventory. You figure it will take 3 weeks running the pop-up store by yourself to sell everything. This will generate $4,000 in sales.
• Vendors offer 2% off if you pay today (so you save $20 if you don’t do the pop-up store), but will charge a 10% fee if you pay in a week (so you’ll need to pay an extra $100 if you do the store).
• The pop-up store location costs $500 per week (cash upfront), making it $1,500 total for 3 weeks.

It looks like a good idea to ignore both the discount and the late fee because the profit you’ll make from the pop-up store will more than compensate. But there’s one more strategic decision you can add here to make even better use of working capital.

Instead of running the store by yourself, you could hire an extra salesperson for $1,200 per week. You’ll be able to serve more customers faster since fewer customers will have to wait to checkout, or they may walk away if you’re serving someone else. This could cut the time needed to sell out your products from 3 weeks down to just 1.

The table below compares the options of doing it yourself vs. hiring the salesperson. Let’s focus on 3 lines:

1. Total working capital needed is $1,000 less with an extra salesperson.
2. Profit is $200 less with the salesperson.
3. Time required is 2 weeks less with the salesperson.

	By Yourself	With Salesperson
Working Capital (Cash)	$1,500 (3 weeks rent)	$500 (1 week rent)
Working Capital (Inventory)	$1,000	$1,000
Total Working Capital Needed	$2,500	$1,500
Sales	$4,000	$4,000
Inventory Cost	$1,000	$1,000
Salesperson Cost	$0	$1,200
Rent	$1,500	$500
Late Fee ($100)	$100	$100
Pre-Tax Profit	$1,400	$1,200
Total Time	3 Weeks	1 Week

 

Even though you made $200 less overall, you saved 2 weeks and you needed $1,000 less in working capital. If you could repeat this over and over for 51 weeks out of the year, you would make $23,800 in pre-tax profit by yourself, but you would make $61,200 with the salesperson. And because you use less total working capital, you could invest that cash saved into other areas of your business to grow even faster.

Factoring receivables is where you sell accounts receivable at a discount in exchange for immediate cash. This is a negative impact to total working capital because you’re gaining less in cash than you’re losing in accounts receivable. However, if you generate a high enough return by investing the cash, it can more than make up for the discount on receivables.

Say that you run a large manufacturing company and you have a major customer that buys so much they can demand great terms on their purchases, like net 90. You’ve needed to upgrade some factory equipment for a while, and the sales rep calls you with one of those “if you sign the PO before the end of the quarter, I can knock off another 15%” type offers.

In this situation, you may not have cash on hand to make a down payment on the equipment. At the same time, you don’t want to pass up this deal because you need the equipment, and the rep usually only offers 5% off when they call.

You look at your accounts receivable and see that your large customer just placed a big order for about the same dollar amount as the cost of the new equipment. Now you can find a factoring company to buy the large client’s accounts receivable from you for a 5% discount.

This gives you the cash you need for the new factory equipment, allowing you to easily meet the customer’s larger order and then some. While you’re giving up 5% on the revenue you would have received in 90 days from the large client, you’re still saving 15% on the equipment you needed to buy anyway.

Also, in terms of future working capital requirements to cover emergency repairs, you’ll already have more cash on hand than you would have otherwise. Or, you could use this cash for other investments in the business including payroll, marketing, and logistics.

You can also use working capital financing in connection with other financing options so you don’t run out of cash flow when you need it, like when an unexpected opportunity falls into your lap.

Let’s say your thriving shirt enterprise gets a call from one of your suppliers. They’re going out of business because their working capital strategy was lacking (they gave customers net 90 while their purchasing team always paid on net 30).

They have tons of raw materials to liquidate in bankruptcy, which you can buy for 70 cents on the dollar. But you have to buy the full boat and it’ll cost you $400,000 cash. Plus, you need to arrange transportation.

The problem is that you already bought this quarter’s $100,000 worth of materials, and because you closely manage your working capital ratio keeping it just above 1, you have just enough current assets to cover your current liabilities.

Nevertheless, you feel that you can’t pass up on this deal because:

• The materials, which don’t go bad/expire, will last for your next 5 quarters and you have plenty of factory space to store them.
• If you pass up on this chance, your aggressive competitor will jump on the 30% discount. They’ll slash prices to steal market share, forcing you into a price war that degrades your margins. It might even cause some wholesale customers to switch suppliers.

Here’s where you can combine strategic working capital decisions with other financing options.  One option could be opening a $50,000 line of credit with your credit union and using an alternative lender for a $10,000 business bridge loan to cover shipping costs. In addition, you could apply for a $350,000 working capital loan to cover the rest of the materials.

These might come with a higher interest rate than a traditional loan from your bank, but they might also come with a quicker approval, which could make all the difference in securing the deal.

In total, you’ve added $400,000 in current assets (inventory raw materials) and you’ve added $410,000 in current liabilities (assuming a 1-year repayment term for the loan and line of credit). This decreases your total working capital ($400,000 – $410,000 = -$10,000 change), but you have no doubt this was the right strategic decision, especially because you avoid a price war with the aggressive competitor.

Pro-tip: As an added benefit, you can deduct the interest paid on the loans to lower your taxable income.

Plus, after you have locked down the deal, you might be able to refinance these new loans into longer-term loans. This boosts working capital by changing short-term debts that detract from total working capital into long-term debts, which don’t.

It can also make sense to invest working capital into long-term business goals, like using a large amount of cash to secure a prime real estate location.

Here’s an example. You’ve picked out your next expansion location. You learned about your city’s strategy for funding major development plans, and a popular anchor tenant has already committed to a development in this town center.

A location right around the corner from the anchor tenant is for sale. Further, because it is early enough in the town center’s development, you can influence the final traffic plan to send more people by your location. But this is going to require a lot of capital. You need a down payment now, a mortgage soon, and a store buildout later. In addition, you’ll need inventory and staff before opening.

To make it happen you can combine working capital strategy with other financing. First, use all cash on hand to make the down payment and secure the location so that no one else can take it. This lowers net working capital.

Next, refinance both your existing short-term debt and the current portion of long-term debt as part of a 10-year term loan. This includes the mortgage for the new location and improves working capital by moving a chunk of current liabilities into long-term debt. Depending on the difference in interest rates between your existing and new loans, it could also help increase working capital by lowering interest expense and letting you keep more cash from operations.

After that, you can renegotiate extended payment terms with your established suppliers by promising higher future orders. This is for the new location you’ll need to stock. Now you can keep cash from existing revenue on hand for a longer period even though it increases your accounts payable.

Even if it turns into a wash in terms of net working capital, having more cash on hand gives you flexibility to cover for emergencies.

To hedge some of the risk you’re taking with a new market, you could pre-fund the initial inventory and staff expenses with new investor equity financing. This boosts your working capital ratio with the influx of cash, but investor equity doesn’t detract from working capital like new short-term debt would.

This combination of working capital and other financing helps you lock down everything you need to execute your long-term strategy, manage your risk, and continue growing your business.

Now you know how managing working capital strategically can help fuel your long-term business success, and you can fine-tune your plans to watch your future path illuminate.