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Know what is working capital & why it is important for Small Businesses

Published On Jun 27 2024 12:06 PM 1 min read 11 views 2312 Likes
Know what is working capital & why it is important for Small Businesses

This mantra has played an important role in most successful businesses. Most businessmen focus on increasing revenue and profits, forgetting the cash flow issues that might kill the business. This makes the working capital one of the most important parts of any business. Let’s begin by understanding what is working capital and why it is important for small businesses to manage their working capital effectively.

What is working capital?

Working capital is nothing but the net current assets that your business owns. It is a metric to calculate the short-term financial health of businesses. It depicts whether the business has adequate financial resources to meet its short-term financial liabilities. Following is the formula to calculate the working capital:

Net Working Capital = Current Assets – Current Liabilities

How working capital issues arise?

Having understood what working capital is, let’s understand how working capital issues arise. You start your new trading business wholeheartedly. You begin purchasing materials and start selling goods. However, your customers ask for a credit of 60 days while you have to repay your creditors in 20 days. So, even if you sold the goods on the very day on which you purchased them, you still will face a gap of 40 days. This is how most businesses face a working capital challenge. Let’s understand why working capital is important for small businesses.

Why is managing working capital important for Small Businesses?

Following are some of the prominent reasons and the importance of working capital management effectively:

  • Cashflow Management: Ensuing a smooth working capital flow is important for efficient cash flow management. It allows small businesses to meet any short-term liability, including contingent liability without compromising on the seamless flow of money.
  • Operational Efficiency: If you wish to maintain operational efficiency, it is important to collect payments on time while also releasing payments to your vendors timely.
  • Profitability: You might be thinking about how cash flow impacts profitability. Well, there are certain ways! Proper cash flow management can reduce your overall borrowing costs. Further, timely payments can help negotiate better pricing terms with your vendors. This can help improve overall profitability.
  • Goodwill and Reputation: Missing out on timely vendor payments can harm the reputation of your business. A proper working capital flow can enhance the reputation and goodwill of your business as it directly indicates a sound financial flow.
  • Proper Inventory Management: Inventory also forms part of the working capital. It shows how much of your capital is tied up in stocks. Proper working capital management will deter you from facing the issues of overstocking, stockouts, etc., as you will try to keep your stock levels optimum.

How to improve working capital?

Here’s how you can improve your working capital management in your business:

  • Improve Receivable Management: To improve your working capital, it is imperative to improve your receivable management. Receiving timely payments is important for the release of timely payments.
  • Negotiate Better Vendor Terms: You can negotiate better vendor terms to get a longer credit period. This will bridge the gap between the time you receive payments from your customers and the time you pay to your vendors.
  • Improve Inventory Management: Inventory management is important to ensure quick inventory turnover and reduce the capital tied up in inventory. There are different ways to manage your inventory, like Just-In-Time, ABC Analysis, Economic Order Quantity, etc.
  • Short-Term Financing: You can bridge the working capital gap by availing of short-term financing facilities like business loans. This will help you release timely payments while waiting for the payments from your customers. However, loans for small businesses do not prevent you from taking other steps as financing comes with an interest cost that reduces your profitability.
  • Monitor Regularly: You should keep an eagle eye on your cash flow management and how your working capital cycle is operating. This ensures prompt action in case things start going south.

In a Nutshell

Managing working capital efficiently lays the foundation for any successful business. You can use the above tactics to understand the shortcomings in your business and take corrective steps to achieve peak efficiency.

In case you still face issues in managing the working capital, you can opt for secured business loans with IIFL Home Loans. With a 100% online process, you can enjoy a hassle-free customer journey in the business loan application process. The approval process is quite efficient and you can get loan approvals in just 30 minutes. Apply now to make your business efficient.

FAQs

Q1: What are the different components of calculating working capital?

Ans:  

The following are the different components of calculating working capital in general:

  • Assets: Cash and cash equivalents, stock, debtors, other current assets, etc.
  • Liabilities: Current liabilities, creditors, short-term borrowings, other current liabilities, etc.

Q2: What are the risks of poor working capital management?

Ans:  

The risks of poor working capital management are increased borrowing costs, damaged reputation, reduced profitability, and ultimately failure of the business.

Q3: How is working capital calculated?

Ans:  

The working capital is calculated by reducing the net liabilities from the net assets to know the net working capital.

Q4: What should I do to improve my working capital if my vendors don't agree to a longer credit period?

Ans:  

Maintaining good relations with your vendors is crucial and therefore, you can consider availing business loans to pay your vendors.

Q5: How to minimize the working capital gap?

Ans:  

You can minimize the working capital gap by reducing the gap between the time you receive payments from your customers and the time you release payments to your vendors. Further, ensure that your stock rotation is fast.

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