What is working capital?

Working capital is the money you use to fulfil your day-to-day financial obligations and keep your operating cycle running. This capital is important in each step of your business cycle, from the purchase of materials, production of goods or services and sales to receipt of payment. If there is a problem in any step in this cycle, such as a need to produce more inventory than planned or more invoices being paid later than 30 days, you will need more working capital.

A deficit in working capital can mean you lose out on growth and new business opportunities. The Allianz Trade Risky Business Report shows that by the end of 2019, 61% of CFOs surveyed had reported that nonpayment increased, disrupting the working capital cycle. Cashflow disruption that impacts operations was the primary concern of those same surveyed CFOs.

Many companies use their accounts receivable as a form of collateral for financing an increase in working capital – a strategy that is becoming more challenging to the financial health of commerce. But there are other methods businesses can use to improve how working capital is managed.

How is Working Capital Improvement Calculated?

In its simplest form, working capital provides a snapshot of how much your current assets exceed your current liabilities. Every business can benefit from understanding how working capital is calculated in order to learn if you have enough money to meet current expenses. The working capital ratio formula to determine financial health is:

Current Assets/ Current Liabilities

A result less than one can indicate there is not enough working capital to meet expenses and manage liabilities. A result greater than 1.5 shows working capital improvement.

Working Capital Improvement Techniques

Making cash flow more predictable in order to fuel your operating cycle for growth can seem easier said than done. These working capital improvement techniques can help.

1. Shorten Operating Cycles

An increased cash flow generates working capital. One way to increase cash flow is to shorten your operating cycle – the process of converting money tied up in production and sales into cash. The longer this process takes, the higher the likelihood of non-payment and the greater impact to your working capital.

Options to shorten your operating cycle and generate working capital faster can include asking for deposits or upfront payment, reducing credit terms and billing as soon as a sale is made. You can also take a harder look at sales forecasting and demand planning, as well.

2. Avoid Financing Fixed Assets with Working Capital

Every business owns or intends to own fixed assets such as buildings, equipment, vehicles or land. These assets are used to generate long-term growth. While selling a fixed asset can boost cash flow and working capital, financing a fixed asset with working capital is never a good idea. Fixed assets tend to be expensive and paying for them not only depletes working capital but increases the risk profile that financial institutions use to determine creditworthiness. A better strategy is to use long-term loans or a lease to finance fixed assets.

3. Perform Credit Checks on New Customers

Before you take on a new client or extend credit, do some research into the prospect’s creditworthiness. This due diligence will help you improve your trade working capital by indicating if a new client is likely to default on payment or pay you on time. Reviewing the new client’s credit report can be helpful. These reports include information from public records about credit history, bankruptcies, or tax liens as well as some payment history. But credit report data becomes obsolete quickly and may not provide a true picture of a client’s or prospect’s current fiscal health.

Equally important in assessing a client’s credit risk is understanding their industry and local market. If you are working with clients in foreign markets, it can be difficult to weigh the economic, political and business risks unique to a specific country. Taking advantage of a risk expert’s knowledge and risk analysis can help protect you against credit risk in international trade. Allianz Trade understands that if you are a multinational company, your financial structures are complex. Our experienced international risk experts can provide you reliable information and help in your credit risk research.

4. Utilize Trade Credit Insurance

A very effective way to increase net working capital is to purchase accounts receivable insurance (also known as trade credit insurance). Trade credit insurance acts as a safety net to protect your business from non-payment of your accounts receivable. This frees you from maintaining bad debt reserves and helps you protect your capital, maintain your cash flow and secure your earnings while extending competitive credit terms to your customers.

Trade credit insurance can also help companies secure working capital financing. Banks usually limit what you can borrow against your receivables because of the perceived risk. But banks consider receivables insured by trade credit insurance as secured collateral. This often means they will lend more money at a lower interest rate to companies that have trade credit insurance.

Trade credit insurance from Allianz Trade includes an additional feature that helps support healthy working capital: risk data. Accessing this data can help businesses increase their net working capital via improved credit control, avoiding bad debt and safely expanding sales to new and existing customers.

5. Cut Unnecessary Expenses

Another way to increase liquidity to support working capital is to cut expenses. Careful analysis of variable business expenses can often uncover savings opportunities through expense reduction or cost cutting. You may also be able to cut expenses to free up some working capital by negotiating with vendors and utilities for discounts, and negotiating better pricing with your suppliers.

6. Reduce Bad Debt

Bad debt, or uncollectible receivables, can happen in any business that extends trade credit. Unfortunately, as bad debt increases, working capital decreases. When you reduce bad debt, you not only increase your net working capital, but you grow. You can take more orders and extend better terms to your customers in order to offer distinctive advantage over your competitors.

Options to reduce bad debt and free up working capital can include selling more higher-margin products or increasing margins across your offerings. Tightening up credit management processes and collecting payments faster is also effective. To combat bad debt, you can reduce inventory by recalibrating stock levels and using just-in-time logistics.

7. Find Additional Bank Finance

A relationship with your financial institution can also be a good hedge against bad debt and a great way to increase working capital. To access financing and receive lower interest rates on loans to support working capital, you must have regular communication with your bank. Share how your business finances are structured, how you generate revenue and what actions you take to protect your margins. This open communication can provide leverage when your financial institution does their risk assessment and due diligence prior to lending you money.

Similarly, to earn an increase in an overdraft facility or a better rate on a receivables finance advance from your financial institution that could increase your working capital, explore the benefits of trade credit insurance. A trade credit insurance policy from Allianz Trade can give you access to powerful information sources that can make determining the creditworthiness of a new client more robust. This ensures your financial institution that your risk management practices are sound.