We often come across people, especially startups and small businesses, who use the term “working capital” in general to refer to current assets that are required to run their business. There is another group of people who use the term “working capital” to refer to the difference between current assets and current liabilities. Even here, some people include cash in their current assets while others do not. So while the concept is relatively simple, the terms associated with it are often used loosely. In this post, we’ll explore various terms related to working capital management, the differences between them, and how to use them for decision-making.
Different types of Working Capital
Simply put, working capital is the capital required for day to day basis working of your business. Now there are three terms that we need to understand here: gross working capital, net working capital, and non-cash net working capital. Gross working capital is simply the sum of a company’s current assets, i.e., assets that can be converted to cash within a year or less and includes the cash and liquid investments that a company is holding. Net working capital is calculated as the difference between gross working capital (current assets) and current liabilities. The non-cash net working capital looks at the difference between non-cash current assets (current assets minus cash and current investment) and operational current liabilities (current liability minus short-term debt). In other words, it is net working capital after removing cash, current investments, and debt, and can be simply considered as receivables plus inventory minus payables.
Non-Cash Net Working Capital for Decision-Making
When analysing the working capital and capital health of a company, the gross working capital will fail to give any useful interpretation. A company may have a huge gross working capital, but in the absence of information on where these assets are expected to get utilized, we cannot judge the working capital’s health. Thus, the useful concept in decision-making is the net working capital, often referred to as “working capital” among finance professionals. The net working capital simply indicates whether, after settling all current liabilities, the company has excess assets on its balance sheet. In general, if this is positive, we say the company’s working capital health is good, and vice versa. But as a treasurer, we use the non-cash net working capital for decision-making. The two components of net working capital, i.e., cash, investment, and debt, are what treasurers control, and therefore, to get a clear picture of the business’s working capital, we ignore these elements and then study the working capital health of the business. In simple terms, we see how much cash is stuck due to credit terms that were extended to customers and the production process, i.e., analysing the receivables and inventory position versus the cash freed due to extended payment terms given by our suppliers. If the non-cash net working capital is negative, it’s better for the company, as your vendors are funding your cash stuck in inventory and receivables.
Strategies for Effective Net Working Capital Management for Treasurers
So why is non-cash net working capital important for treasurers? For one thing, if non-cash net working capital is positive, it means businesses need funds to continue their operations, and if it is negative, it means businesses have to invest surplus funds in productive assets. In either case, the Treasury Department team is called upon to handle the situation. Today’s treasuries are going beyond traditional working capital gap funding or surplus investment funding to innovative solutions like supply chain financing, dynamic discounting, sustainable financing, etc. They are expected to analyse every aspect of the business, from procurement to sales realization. By closely monitoring the components of net working capital, treasurers can identify potential cash flow issues and take action to address them.
So how can treasurers manage net working capital effectively? Here are some strategies to consider:
- Optimize inventory management: By keeping the right amount of inventory on hand, treasurers can minimise the amount of cash tied up in inventory while still meeting customer demands.
- Improve accounts receivable collection: On one side, this involves negotiating shorter payment terms, and on the other, it involves establishing receivables sales programs, PO financing programs, dealer financing programs, etc.
- Manage accounts payable: The procurement team can, at their end, try to maximise the payment terms directly with the vendors, or the treasury team can look at some vendor financing and dynamic discounting programs.
- Improving Analytics: Today’s data is the new oil. By improving the data visibility the treasurers can have insights that will help them pinpoint the core issue and solve for it.
- Becoming Sustainable: It is critical that while we work on working capital solutions, we explore the sustainability aspects of working capital as well. In the future, sustainability will be a differentiator regarding business continuity.
In summary, effective management of net working capital creates sustainable value by providing decision-makers with much-needed insights and reaction agility. It also strengthens the company’s financial position and is an important pillar of Treasury Management. By understanding the differences between various terms related to working capital, knowing how to calculate them, and implementing strategies for managing it effectively, treasurers can help ensure that their companies have the cash they need to meet short-term financial obligations and keep the business running smoothly.