Last Updated on October 12, 2023
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 – particularly small businesses – which forces entrepreneurs to get creative to combat this problem.
While business owners struggle to come up with adequate capital for a multitude of reasons, not getting paid on time is at the very top. And not getting paid on time leads to cash flow problems, which leads to working capital problems.
These types of business hinderances can be stressful, which is why 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 the total amount of capital you invest in your company’s daily operations, and it is the difference between your company’s current assets and current liabilities.
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 is not 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:
- 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.
- 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.
- 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.
- 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.
10 Ways to Improve Working Capital
After you’ve calculated 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 common obstacle for business owners. If you need to improve your working capital, implementing the 10 straightforward tips below to your business can give you 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 you lengthen the time your money is out the door and preventing customers from sending 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. Collect Invoice Payments on Time
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
3. Shorten Invoice 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.
4. Offer Early Payment Discounts and 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 small percent of your earnings as discounts, you will have more working capital available to run your business.
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. Use Invoice Factoring
Invoice factoring is an alternative financing option that is designed specifically for small business owners looking to improve their working capital. The factoring process involves a third-party factoring company managing your accounts receivables collections. Once you sell an invoice to the factor, you’ll be advanced 80-90% of the value of the invoice, introducing quick, scalable funding for your business.
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.
10. Negotiate Better Payment Terms with Vendors
It can be difficult to secure long payment terms with suppliers as a new business or new customer because they do not have an understanding of your payment behaviors. However, after working with a vendor for a while, you can build a relationship with them, which gives you a much better foundation to negotiate your payment terms. Once you have established yourself as a reliable customer that makes on-time payments and does not create bad debt, you are in a good position to negotiate longer payment terms, which can give you more flexibility to make payments on a schedule that fits your company’s needs.
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.
Jim is the General Manager of altLINE by The Southern Bank. altLINE partners with lenders nationwide to provide invoice factoring and accounts receivable financing to their small and medium-sized business customers. altLINE is a direct bank lender and a division of The Southern Bank Company, a community bank originally founded in 1936.