Working Capital Management: What is it and How Does it Work?

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 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.

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.

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 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 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 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 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. 

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.

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 Financial

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 Financial’s flexible financing solutions offer access to up to $500,0001,2 in working capital, with terms extending up to 12 years1 for affordable monthly payments. You can learn more about BHG Financial's working capital loans here, and view your personalized loan estimate today.