Working capital management: What is it and how does it work?

Establishing and maintaining a business necessitates a focus on financial matters such as working capital management, which revolves around the smart handling of operational funds and liquid assets within an organization. Proper working capital management can lead to profitability and sufficient cash flow to meet short-term demands of both debt and operating costs.

There are various components of working capital, which may include:

Cash—Evaluating cash entails monitoring and optimizing an enterprise's cash reserves to ensure they are well-positioned to meet immediate financial demands and maintain liquidity.
Receivables—Receivables means efficiently collecting payments from customers or clients who are indebted to the company, thereby generating consistent cash flow. This may include open invoices, outstanding credit, and accrued interest.
Payables—Payables involve the company's outstanding obligations to suppliers, creditors, or vendors, often involving the optimization of payment terms. This may include accrued bills, outstanding dividends, future tax payments, and day-to-day operational costs.
Inventory—Inventory requires that you strike a balance between sustaining adequate stock to meet consumer demand and minimizing excess inventory that may hinder capital. This may consist of items on display in physical establishments or stored within facilities.

The principal aim of working capital management is to ensure that a business has the requisite financial resources to operate seamlessly. Such resources are indispensable for sustaining day-to-day functions, meeting short-term financial commitments, surmounting financial hurdles, and maintaining strong liquidity.

Keep reading to examine what working capital management means for businesses and for insight into how it may be managed more effectively.

Types of working capital
There are various types of working capital, each of which is calculated in a different way. When evaluating the working capital of your business, it's important to keep in mind how each type is different, so you have the appropriate funds in place.

Permanent working capital

Permanent working capital is the minimum working capital required for the smooth operation of a business. It’s calculated based on the level of operation, the minimum inventory required, and the regular payment cycle. Typically, permanent working capital remains relatively stable over time, with fluctuations arising only in the event of significant changes in the business model or market conditions.

Regular working capital

As an integral part of permanent working capital, this subsegment is comprised of the funds necessary for day-to-day operations. Regular working capital includes resources for expenses such as salaries, rent, and utilities. Such working capital is a perpetual requirement, always available to ensure the unhindered functioning of the business.

Reserve margin working capital

Termed as "cushion" working capital, this is the additional money retained by businesses above their regular working capital. It serves as a safety net to cover unanticipated expenses, including economic downturns, natural disasters, or labor strikes.

Variable/fluctuating working capital

Variable working capital fluctuates in tandem with the ebb and flow of business activities. For example, a business may need more funds to accommodate an increased customer base or heightened sales. Therefore, the amount of capital needed is not always constant—it varies depending on business needs.

Seasonal working capital

Seasonal working capital may be indispensable for businesses experiencing demand fluctuations during specific periods of the year. For instance, retailers often encounter heightened demand during the holiday season, necessitating additional resources for inventory and the hiring of additional staff. Seasonal working capital is typically of a temporary nature and is employed to facilitate the enterprise's adaptation to shifts in demand.

Gross working capital

Gross working capital is the aggregation of a company's current assets, including inventory, cash, accounts receivable, and other assets that may be readily liquidated to meet operational expenses and financial obligations if necessary.

Net working capital

Net working capital serves as a representation of the financial resources available to businesses for their daily operations after offsetting their prevailing liabilities. It’s calculated as the difference between current assets and current liabilities. It generally provides an accurate indicator of a company's financial well-being and is widely employed in the assessment of working capital.

How to calculate working capital
The calculation of net working capital involves the simple deduction of current liabilities from current assets. Current assets encompass cash, accounts receivable, and inventory, while current liabilities may include accounts payable, accrued expenses, and short-term loans. This calculation may be expressed through the following formula.

For instance, if a manufacturer's assets total $200,000 and liabilities amount to $130,000, the net working capital is $70,000.

For additional insight into the short-term health of a business, you can also use these figures to calculate its working capital ratio.

Why is managing working capital important?
Efficient working capital management may ensure that a company has the resources to maintain the seamless execution of operations and capitalize on growth opportunities. Failure to manage working capital effectively could lead to cash shortages, an inability to meet financial obligations, and, in a worst-case scenario, bankruptcy.

Therefore, the management of working capital is indispensable for any business aspiring to sustain financial stability and secure long-term success. Strategies for such effective management may consist of the following.

Increasing inventory turnover—Increasing inventory turnover involves increasing the frequency of sales for each item within a specific timeframe to boost revenue. This may help generate more sales while reducing costs associated with storing and managing inventory. Companies can raise sales by automating inventory tracking, improving stock ordering, exploring new marketing channels, and discounting slow-moving inventory.
Paying vendors on time—Making timely payments to vendors is essential to avert costly late fees and interest charges that could jeopardize working capital.
Transition to electronic payables and receivables—Embracing digital processes may streamline accounts payable and accounts receivable, potentially saving time and financial resources while enhancing accuracy and accountability throughout the organization.

Transform your operations with BHG Money
Working capital management represents a pivotal facet of business operations. Taking the time to understand and optimize your working capital management may help guarantee that your business runs smoothly and efficiently.

Should the need arise, financing options, including loans, may provide invaluable support in meeting working capital requisites.

BHG Money’s flexible financing solutions offer access to up to $500,000^1,2 in working capital, with terms extending up to 12 years¹ for affordable monthly payments. You can learn more about BHG's working capital loans here, and view your personalized loan estimate today.

¹ Terms subject to credit approval upon completion of an application. Loan sizes, interest rates, and loan terms vary based on the applicant's credit profile. Finance amount may vary depending on the applicant's state of residence.
² BHG Financial business loans typically range from $20,000 to $250,000; however, well-qualified borrowers may be eligible for business loans up to $500,000.
No application fees, commitment, or impact on personal credit to estimate your payment.
For California Residents: BHG Financial loans made or arranged pursuant to a California Financing Law license - Number 603G493.