How to Improve Working Capital

Last Updated July 22, 2024

Working capital is vital to any business and is an essential indicator of short-term financial health. Unfortunately, businesses all over the world commonly suffer from a lack of working capital, forcing entrepreneurs to get creative to combat this problem.

While business owners struggle to come up with adequate capital for a multitude of reasons, a few of these reasons are avoidable. For example, not getting paid on time is a common obstacle that leads to working capital problems, but there are methods you can implement to prevent that from happening and, instead, improve your chances of invoices being paid quicker.

These types of business hindrances can be stressful. Therefore, we’ve put together a list of 10 ways to improve your working capital. But before we dive into that, let’s briefly define working capital and underline its importance.

What Is Working Capital?

Working capital is simply the difference between your company’s current assets and current liabilities, resulting in an amount that you can then reinvest into your business and its daily operations.

The formula for calculating your working capital is as follows:

Working Capital = Short-Term Assets – Short-Term Liabilities

Improving working capital can lead to:

• More efficient business operations
• An ability to pay-off unexpected costs
• Opportunities for business expansion

How Much Working Capital Do I Need?

The amount of working capital you need depends on the scale of your business operations and type of company you own. For instance, the working capital a startup restaurant needs won’t be the same as the working capital an established manufacturer needs.

You can use the working capital ratio to evaluate if you have enough working capital or not. The formula for working capital ratio is as follows:

Working Capital Ratio = Short-Term Assets / Short-Term Liabilities

A good working capital ratio is typically between 1.5 and 2, meaning you have enough capital on-hand to cover all of your short-term expenses plus some.

Below are some additional factors that affect how much working capital you have:

1. Quick Payment of Suppliers: Suppliers who want to be paid quickly will cause you to have a lower working capital as opposed to those who do not mind waiting for payment.
2. High Staffing Needs: Labor is usually paid faster than materials, so if your business is labor based, it can affect the amount of working capital you have. Businesses that are highly affected by this include staffing agencies and professional service providers.
3. Payment Collection: A business model that sends invoices to collect customer payments will have a lower working capital compared to a model where customers pay fully before service.
4. Long Customer Payment Cycle: If your business runs on longer payment terms, such as net 30 or net 60, you’ll likely find yourself with less working capital.

9 Ways to Improve Working Capital

Now that you have an understanding of what working capital is and how much working capital your business needs, you may find that your business is lacking in this department.

But don’t worry, this is a normal challenge for business owners. If you need to improve your working capital, implementing the following working capital improvement tips will give your business a significant boost.

1. Send Invoices Quicker

Sometimes your commitment to providing clients with top-notch value can result in performing your back-office work slowly, including the time it takes for you to send out invoices. This can hurt your business as it prolongs payment. Sending your invoices quickly ensures your clients receive their bills sooner and gives them time to pay speedily, creating positive cash flow and improving your access to working capital.

2. Shorten Payment Terms

It can be confusing to decide what payment terms you should offer your clients. Net 30 tend to be the standard, but these terms result in you most likely waiting 30 days or more for payment, which can leave you strapped for cash.

Short invoice payment terms, such as Net 7 or Net 10, help you get paid in a timely manner, keeping cash flowing into the business, and quick payments mean more available funds for maintaining or scaling business operations.

3. Prioritize Communication with Your Slow-Paying Customers

As a business owner, you have many responsibilities, so it is easy to forget about outstanding invoices and past due accounts. In fact, Chaser found that 87% of businesses get paid late, which can result in slower cash flow and less working capital.

Collecting invoice payments before they are past due is a great way to inject working capital into your business. If you struggle with late-paying customers, below are a few tips to encourage timely payment:

• Follow up on each invoice
• Offer electronic payment options
• Use multiple channels to follow up on payments, such as email and SMS messaging
• Use back office outsourcing services or work with a factoring provider to handle collections

According to Jeff Mains, CEO of Champion Leadership Group, mastering chasing down payment is about finding the balance between persistent outreach to customers, while maintaining professionalism to prevent losing valuable business.

“Professionalism and empathy are key in these communications,” Mains said. “I started conversations by acknowledging the valued relationship with the customer. By opening this dialogue, we often found mutually agreeable solutions and reinforced trust with our customers, showing them we’re partners in their success, not just creditors.”

4. Offer Early Payment Discounts and Late Payment Fees

One way to encourage slow-paying customers to pay quicker is by offering early payment discounts, or alternatively, implementing late payment fees.

When you offer early payment discounts or introduce late payment fees, you motivate your customers to pay you more quickly. Even though you might lose a very small percent of your earnings as discounts, you will have more immediate working capital available to run your business, which typically makes up for it.

Some examples of common early payment discounts include 1/10 net 30 and 2/10 net 30, meaning that customers on net 30 terms get a 1% or 2% discount, respectively, if they pay within the first 10 days.

Do keep in mind that it’s important to be cautious with enforcing late fees. Blake Rutledge, CFO of Kruze Consulting, has a wealth of experience negotiating contracts for small businesses across a variety of industries. According to Rutledge, business owners must gauge which clients require a stricter approach vs. which clients should be provided more leeway.

“You need to be careful,” Rutledge said. “It’s always good to have some sticks and carrots in your contracts. But let’s say this is a customer you want to keep selling to over and over. Jabbing them with a little extra interest charge—is that the sort of relationship you want to have? That’s something you need to consider.”

An example of an important consideration is the difference in value between one-time buyers and recurring customers—the latter of which warrants extra thought and care.

5. Improve Inventory Management Practices

Inventory management practices such as knowing what stock to order, how much you need, and when you need it can make a big difference in your operating efficiency. Having sound inventory management practices can ensure you do not tie up your capital in inventory and can help you avoid a shortage of inventory when you need it most. By improving your inventory management practices, you can get the most out of your materials and products and increase your available funds.

If you are not sure how to improve your inventory management, consider the following tips:

• Track your sales, including how much of which products you’ve sold
• Prioritize your inventory, taking stock of which items you need more of, and which items sell more slowly
• Use a good supplier, and avoid working with a vendor that is consistently late with deliveries
• Account for your inventory, using either first-in-first out (FIFO) costing, last-in-first-out (LIFO) costing, or weighted-average costing

6. Utilize Invoice Factoring

Invoice factoring is an alternative financing option that is designed specifically for small business owners looking to improve their working capital.

Factoring involves a dedicated invoice factoring company (a “factor”) that will help manage your AR collections, and the process is pretty straightforward. Once you’ve signed a factoring agreement, you sell your unpaid invoices to the factor, who then advances the majority of the value of each invoice to your business, introducing quick, scalable funding for your business.

Factoring is tailored for small business owners because they are at greatest risk of slow-paying customers jeopardizing their working capital. Plus, it’s one of the most attainable ways to finance a business since there’s no minimum credit requirement and no need to sacrifice collateral in the form of hard assets, both of which can make it challenging for small business owners to qualify for more traditional financing options.

Related: Why Do Businesses Use Invoice Factoring?

7. Lease Equipment

It can be tempting to purchase your equipment since it typically results in paying less for the machinery in the long run. However, acquiring equipment on lease instead of purchasing it outright can help you keep more working capital available. Additionally, lease payments tend to be cheaper than equipment loan payments, making it a more approachable option for many business owners.

8. Use Trade Credit Insurance

Trade credit insurance provides you with financial coverage if your customers are unable to pay. This can be helpful for businesses that are concerned about high-risk customers or new customers that may not pay their debts. While trade credit insurance will not immediately increase working capital like some of the other solutions outlined in this article, it is a method of protecting your cash from bad debt. Additionally, having trade credit insurance could help you secure better financing terms from a lender as it provides them with a safety net as well.

9. Perform Credit Checks on Customers

Performing credit checks is essential to evaluating your customers’ financial history. Do they pay on time? Do they default on payments? Do they have underlying issues that impede their financial capabilities? Knowing the answers to these questions will give you a better idea of your customers’ creditworthiness so that you can choose to work with clients you trust will pay.

Switching back to tip No. 6, an invoice factoring company like altLINE will actually perform credit checks on your customers as part of the review and onboarding process (for free!). If you don’t want to dedicate the time or money to checking your customers’ credit history, a factor can actually do it for you if you choose to work with them.

In-Summary: How to Improve Working Capital

Ultimately, there are numerous tried-and-true methods to improve working capital. The best will depend on your particular circumstances. Maybe it’s your inventory that could use more attention, or maybe your payment terms are what’s holding you back.

Regardless, learning how to improve working capital is just one component of completing a working capital analysis.

It’s equally important to learn what causes working capital changes within your business because that’s when you’ll gain the most holistic understanding of what might be preventing you from maximizing your potential.

Need to Quickly Improve Your Working Capital? Give altLINE a Call

Do you think invoice factoring is the best solution to improve your working capital? Call one of our representatives at +1 (205) 607-0811 or fill out our factoring quote form. We would be happy to discuss how invoice factoring can help accelerate your business and meet your cash flow needs.

How to Increase Working Capital FAQs

Can working capital improve your profitability?

Yes, the more working capital a business has, the better chance it has of being a profitable company as the owner can invest more money back into the business.

Additionally, having sufficient working capital is important not only because it covers day-to-day operational costs, but because it provides a safety net in case of financial disaster. While this doesn’t directly lead to increased profitability, it improves a business’s chances of survival and long-term health.

How can you reduce your working capital cycle?

The working capital cycle is the amount of time it takes for a company to turn its current assets into cash, and many smaller companies struggle with maintaining a consistent, healthy working capital cycle. However, there are steps you can take to change or prevent that.

For example, offering early payment discounts to customers and reducing payment terms can put money in your pocket quicker when it comes to managing AR. Invoice factoring is an alternative financing option that many small business owners utilize to improve working capital. Leasing equipment, rather than buying, can also be a great way to save money and ensure you still have sufficient capital.

How much working capital should a company have on-hand?

How much working capital a company needs completely depends on a multitude of factors. However, a useful way to measure exactly how much operating capital you should have readily available is by utilizing the current ratio formula (or working capital formula): current assets / current liabilities.

Generally speaking, a ratio between 1.5 and 2.0 is healthy and reveals that you have sufficient working capital to cover costs. If your ratio is below 1.5, that means you might have working capital problems.