Companies do not fully exploit the potential and opportunities when it comes to working capital, whereby in most cases it leads to more liquidity and less risk. Due to a good economy and low interest rates in recent years, which provided sufficient liquidity, companies paid little attention to working capital management, but since the outbreak of the pandemic, the liquidity situation has changed drastically for many companies, making it necessary to secure or increase liquidity.
What is working capital?
Working capital is a key figure in balance sheet accounting and is used to analyze the liquidity of a company. Working capital represents the difference between current assets and current liabilities.
Working capital = current assets – current liabilities
The value of working capital should be greater than zero; positive working capital signals that all fixed assets and parts of current assets have been financed by long-term capital. This approach follows the so-called golden balance sheet rule: fixed assets and long-term current assets are financed by long-term capital. Working capital should have a ratio of 2 : 1 between current assets and current liabilities.
Working capital = current assets current liabilities
In the case of negative working capital, the value is less than zero. In this case, there is a risk that the company does not have sufficient liquidity and the risk of illiquidity is higher because current assets are not sufficient to cover current liabilities.
The higher the working capital, the more secure the liquidity and investment scope of the company.
Difference between gross and net working capital
A distinction is made between gross working capital and net working capital.
- Gross working capital (total): It provides information on the available liquidity or financing scope.
- Net working capital: It provides information on the potential availability of current assets after deduction of current liabilities. As it is more meaningful, it is considered to be more important than gross working capital.
What is the significance of working capital?
The working capital ratio shows the percentage of current liabilities covered by current assets. Care should be taken to ensure that this ratio is permanently greater than 100 %; working capital is then balanced and above 0. A rule of thumb is a working capital ratio of at least 120 – 130 %.
However, the informative value of working capital is limited because it is a static indicator. Future cash flows (expenses and income), for example, are not taken into account, so that an incorrect assessment of liquidity can take place. Furthermore, working capital also depends on the industry.
Nevertheless, the balance sheet ratio can be used to identify optimization opportunities. Among other things, working capital provides indications of poor inventory management, management problems of payables, or poor receivables management, although these assumptions can be confirmed or refuted with the help of further analysis.
Definition: Working Capital Management
Working capital is therefore defined as net current assets, i.e. the difference between current assets and current liabilities. Working capital management is used to manage current assets and current liabilities, i.e. current assets and current liabilities are managed.
More precisely, inventories are stored for as short a time as possible, supplier invoices are settled as late as possible, and for receivables, incoming payments can be realized as early as possible. In this case, sufficient liquid funds are available for investments or the growth of the company.
Accordingly, working capital management is responsible for releasing cash tied up in current assets.
Working capital management (WCM) is considered a tool for strategic controlling, risk controlling and financial controlling. The management is to contribute to an increase in efficiency, the optimization of tied-up cash and cash equivalents and the improvement of the financial structure. Liquidity bottlenecks are to be identified in good time in order to be able to intervene accordingly.
Working capital management is an important tool for companies to strengthen liquidity. However, it is too often neglected and not practiced by companies. If too much capital remains tied up, companies do not take advantage of the opportunity to optimize their financial situation. Improvisation of key figures can be achieved through optimized warehousing and product range, but also through improved receivables and accounts payable management.
- Optimized warehousing: Inventories must be controlled and the warehouse layout must be sensibly designed so that goods can be found quickly. Just-in-time deliveries reduce storage costs.
- Optimal product range: analysis of turnaround times to adapt production and storage for products with long turnaround times.
- Optimized receivables management: Correct deficiencies in payment terms and in the collection of receivables. A good dunning system and credit checks can be helpful here. Discounts can improve the speed of customer payments.
Working capital management measures
As indicated in the section above, the three main areas of working capital management are:
- Receivables management (order to cash)
- Liability management(purchase to pay)
- Inventory or warehouse management(forecast to fulfill)
Receivables management (order to cash)
Receivables management is of essential importance for securing liquidity. If a company provides services without customers paying the invoices on time or at all, the liquidity crisis is pre-programmed. For this reason, open receivables must be monitored, incoming payments must be documented, and outstanding incoming payments must be reminded promptly if necessary.
Key elements of receivables management(order to cash) are establishing valid financial and credit policies, simplifying and accelerating receivables liquidation, ensuring timely invoicing, and increasing customer satisfaction. Credit checks can prevent payment defaults and individual credit lines can be issued.
Receivables management is not always carried out by the company itself, as many companies outsource it. In this case, service providers take over the dunning or collection process. So-called factoring companies buy the outstanding receivables for a fee and thus offer the company quick liquidity with the help of the sale of receivables. Factoring secures the receipt of payments and reduces the risk of default. Medium-sized companies in particular frequently use this form of financing.
| Area | Measure |
| Credit Risk Management | Credit check |
| Contract design | Advance payments, payments on account |
| Invoicing | Timely invoicing, granting of discounts |
| Collection Management | Tightening of dunning procedures, factoring |
Liability management (purchase to pay)
Another component of working capital management is payables management(purchase to pay), whereby, for example, maximum payment potential is exploited by taking advantage of long payment terms or maximum cash discounts. The supplier structure is designed to optimize purchasing efficiently. Aiming for the longest possible accounts payable period ensures that, all other things being equal, tied-up capital decreases.
| Area | Measure |
| Supplier strategy | Reduce number of suppliers |
| Terms of payment | Standardize and harmonize payment terms |
| Payment history | Exploit cash discount, reduction of payment runs |
| Monetary transactions | Fast and error-free payment posting |
Warehouse Management (Forecast to Fulfill)
And finally, we would like to talk about inventory management(forecast to fulfill), which is one of the three essential areas of working capital management. The warehouse is a balancing element between the procurement, production and distribution processes. It gives the company flexibility in terms of the timing of procurement of goods, planning of production orders and provision of goods (serving demand). Reducing inventories frees up working capital and can help increase liquidity.
Overcrowded warehouses with goods that are not used and sold for a long time should be avoided as much as possible. Ordered and paid goods, which are not used for a long time, only unnecessarily tie up the capital, which initially generates no revenue, but costs. The goal should be to free up cash to make other more important investments. Stock financing from fulfin would be an alternative financing option for this.
| Area | Measure |
| Sales planning | Improve demand forecast |
| Purchasing Management | Reduce number of suppliers, use just-in-time concept |
| Production Management | Late variant formation, standardization production |
| Warehouse Management | Reduce safety or buffer stocks |
| Delivery | Minimize transport routes |
Securing liquidity through working capital management
The aim of working capital management is to secure and increase the company’s liquidity and optimize profitability. For this purpose, an analysis of the balance sheet is carried out and, if necessary, the conditions with suppliers are renegotiated or adjusted. The optimization measures should then have a positive impact on the liquidity ratios. As a result, the company is better valued by investors and lenders, giving it access to further financing options.
Establish working capital management as a corporate goal
Working capital management should be at the top of management’s priority list in order to identify liquidity bottlenecks and too much tied-up capital more quickly so that the company can intervene accordingly. Often, only profit development or sales are considered, but even if sales are growing, the company must remain liquid.
If more sales are generated, this initially looks good, but if the invoices issued are not paid for longer and longer, the company goes into prepayment for a very long period and has to wait for the incoming payments.
Sufficient liquidity must be available for the company’s growth – otherwise the company can quickly become insolvent – despite good business. Working capital management can identify undesirable developments at an early stage and take the necessary measures.
Conclusion
Intelligent and forward-looking working capital management is worthwhile for all companies in order to avoid financial instability, release tied-up liquidity, create scope for investment and mitigate the risk of a liquidity shortage, as well as improve creditworthiness and finance corporate growth.
Working capital, which is the difference between current assets and current liabilities, should be positive, otherwise there is a risk of a liquidity bottleneck. The greater the working capital, the more scope the company has for investment. Instruments such as factoring, inventory or commodity financing should also be part of professional working capital management. This involves the sale of trade receivables in order to make money quickly available. Thus, the company is quicker liquid again than waiting for the receipt of payment. Inventory financing, on the other hand, releases liquidity tied up in inventory in order to invest capital elsewhere. If corresponding liquidity bottlenecks arise, fulfin can help companies to bridge these bottlenecks by providing customized financing solutions .
FAQ – Working Capital Management
What is the significance of working capital?
Working capital is calculated as the difference between current assets and current liabilities: Working capital = current assets – current liabilities. Current assets include bank balances, trade receivables and other receivables of the company. A positive result means that a company’s current assets cover its current liabilities.
What is working capital management?
Working capital management is a tool of strategic controlling, risk controlling and financial controlling and deals with the management of the company’s current assets and current liabilities. The aim is to optimize tied-up capital and bring about an improvement in the company’s financial structure, while at the same time reducing the risk of liquidity bottlenecks.
How to improve working capital?
Working capital improves when tied-up capital is released, e.g. receivables sold through factoring or reduced by improving the dunning process. Attempts should be made to use freed-up funds sensibly, e.g. for the repayment of liabilities or for investments to create additional sales.
How is working capital calculated?
Working capital is calculated as the difference between current assets and current liabilities: Working capital = current assets – current liabilities.
Why is working capital important?
Working capital is a significant ratio necessary for calculating and evaluating a company’s liquidity. Working capital is also referred to as net current assets and largely corresponds to 3rd degree liquidity. Positive or increasing working capital indicates that the company’s liquidity position is adequate or improving. A negative value indicates that non-current assets are financed on a short-term basis and that the company’s liquidity position is unstable.
Why is working capital management important for the success of a company?
In order for a company to be successful in the long term, it is essential to ensure liquidity and profitability. The management of operating assets, or more precisely working capital management, plays a central role here. It is important in order to balance high capital commitment and possible liquidity bottlenecks and to prevent losses. The management of current assets, working capital management, is a crucial measure for increasing business value and operating profit.