Companies do not take full advantage of 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, so that securing or increasing liquidity is necessary.
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 . A positive working capital signals that the entire fixed assets and parts of the current assets were financed by long-term capital. This approach follows the so-called Golden Balance Rule: The Fixed assets and the non-current current assets need to be broken down by long-term capital financed. Working capital should have a ratio of 2 : 1 between current assets and current liabilities.
Working capital = Current assets Current liabilities
If the working capital is negative the value is less than zeroas well . 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 (gross current assets) and net working capital (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. Since it is more informative, it is considered to be more important than gross current assets.
What is the significance of working capital?
The working capital ratio shows the percentage of current liabilities that are covered by current assets. Care should be taken to ensure that this ratio is permanently greater than 100 % The working capital is then balanced and is 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, as it is a static key figure deals. Future cash flows (expenses and revenues), for example, are not taken into account, so that an incorrect assessment of liquidity can take place. Furthermore, the working capital is also industry-dependent.
Nonetheless, the balance sheet ratio can be used to optimize possibilities to be identified. Working capital provides indications of, among other things, poor inventory management, liability management problems or poor receivables management, although these assumptions can be confirmed or refuted with the help of further analyses.
Definition: Working Capital Management
At Working capital is therefore understood to be the Net working capital:, i.e. the difference between current assets and current liabilities. Due to the Working Capital Management current assets and current liabilities are managed, i.e. current assets and current liabilities are managed.
More precisely, inventories are stored as short as possible, supplier invoices are paid 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.
The Working Capital Management (WCM) is considered a tool of the strategic controllingof the Risk and of the Financial Controlling. The management should contribute to an increase in efficiency, the optimisation 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. An improvisation of the key figures can be achieved by an optimized warehousing and Product range, but also by an improved receivables and accounts payable management achieve.
- Optimized warehousing:Stocks must be controlled and the warehouse layout must be sensibly designed so that the goods can be found quickly. Just-in-time deliveries reduce storage costs.
- Optimal product range: Analysis of turnaround times to adjust 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 help with this. Discounts can improve the payment speed of customers.
Working capital management measures
As indicated in the above section, the three main areas of working capital management are:
- Receivables management (order to cash)
- Commitment management (purchase to pay)
- stock 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, if necessary, outstanding payments must be reminded in a timely manner.
Central elements of the Receivables management (order to cash) are to establish valid financial and credit guidelines, simplify and accelerate the liquidation of receivables, ensure timely invoicing and increase 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 this. 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 often use this form of financing.
|Credit risk management||Credit check|
|Contract design||Advance payments, payments on account|
|Invoicing||Prompt invoicing, granting of discounts|
|Collection Management||Tightening of dunning procedures, factoring|
Liability management (purchase to pay)
Another component of working capital management is liabilities management (purchase to pay), whereby, for example, maximum payment potentials are exploited by taking advantage of long payment terms or maximum cash discounts. The supplier structure should optimize purchasing efficiently. Aiming for the longest possible accounts payable period ensures that tied-up capital decreases, all other things being equal.
|Supplier strategy||Reduce number of suppliers|
|Terms of payment||Standardize and harmonize payment terms|
|Payment history||Take advantage of 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 mention Warehouse 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 when to procure goods, schedule production orders, and make goods available (meet demand). Reducing inventory 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 far as possible. Ordered and paid goods that are not used for a long time only tie up capital unnecessarily, which initially generates no income but costs. The goal should be to free up cash to make other more important investments. A Inventory Financing: of fulfin would be an alternative financing option for this.
|Sales planning||Improve demand forecast|
|Purchasing Management||Reduce number of suppliers, use just-in-time concept|
|Production Management||Late creation of variants, standardization of 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 liquidity of the company and to optimize profitability. For this purpose, an analysis of the balance sheet is carried out and, under certain circumstances, the conditions with suppliers are renegotiated or adjusted. The optimization measures should then have a positive effect on the liquidity ratios. As a result, the company is rated better 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 looks good at first, but if the invoices issued are not paid for longer and longer, the company goes into prepayment over a very long period of time 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.
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 reduce the risk of a liquidity bottleneck, as well as improving creditworthiness and financing 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 investment scope the company has. Instruments such as factoring, inventory or commodity financing should also be part of professional working capital management. Here, trade receivables are sold in order to make money quickly available. In this way, the company becomes liquid again more quickly than having to wait for incoming payments. With inventory financing, on the other hand, liquidity tied up in inventory is released in order to invest capital elsewhere. If corresponding liquidity bottlenecks arise, fulfin can be financed through tailored finance solutions Companies help to bridge these bottlenecks.
FAQ - Working Capital Management
What is the importance 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 the 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 are sold through factoring or reduced by improving the dunning process. At the same time, an attempt 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 an important ratio that is necessary for calculating and evaluating the liquidity of a company. Working capital is also referred to as net current assets and largely corresponds to third-degree liquidity. A positive or increasing working capital indicates that the company's liquidity position is adequate or improving. A negative value indicates that long-term assets are financed in the short term 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 secure liquidity and profitability. The management of operational assets, or more precisely, working capital management, plays a central role in this. 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 decisive measure for increasing the value of the business and the operating result.