Which is more important: hoarding cash to maintain a strong working capital or running it low to capitalize on opportunities? During the COvid-19 crisis, finding the right balance between assets and liabilities has become increasingly difficult.
Your company will go bankrupt if you can’t pay your bills; however, if you don’t put money into your business, you will be left behind in the future. You can achieve that balance by determining and assessing your company’s working capital requirement.
Assessing your WCR
A Financial Metric called working capital requirement (WCR) indicates how much the number of financial resources you require to cover production costs, upcoming operational expenses, and debt repayments. In other words, it reveals how much money is required to finance the difference between payments from customers and payments to suppliers.
Calculating your WCR
Accounting receivables, inventory, and accounts payable are key components of the working capital requirement formula. You can use the following formula to calculate working capital requirements:
Working Capital Requirement=Inventory+Accounts Receivable-Accounts Payable
Understanding changes in the WCR limits
Look at the working capital requirement components first if you’re wondering how to analyze them. In WCR, a rise in accounts receivables, a rise in inventory, or a decrease in accounts payable causes a rise.
Companies with high working capital requirements usually spend a lot of financial resources just running their businesses, which leaves them with little money for other objectives, such as new product development, geographic expansion, acquisitions, modernization, or debt reduction. Making forward-looking investments is harder if you have a high working capital requirement. Keep an eye on it!
Working capital ratio
Using working capital ratios, you can see whether your company can pay for its current liabilities with its current assets. However, a working capital ratio doesn’t result in a hard number like the working capital requirement but rather a percentage or a measure of the number of assets concerning liabilities in your company.
A rule of thumb is to have a working capital ratio of 1.5 to 2, indicating a company is financially sound as far as liquidity is concerned. Working capital ratios that are less than one indicate potential liquidity issues in the future.
A business that generates cash very quickly and sells products before paying its suppliers will have negative working capital to account for. More and more companies are using financing structures such as factoring and reverse factoring to improve their working capital and cash flow.
Factors that influence WCR
In terms of working capital requirements, payment delays are the biggest drain. Even in the best of times, companies that receive late payments have to draw on their working capital to pay the bills, and payment delays lead to insolvency.
Suspension of payments leads to business failures. You can manage a company’s cash flow carefully. Track customer payments, for example, by asking customers to acknowledge invoices sent and sending reminders when customers breach payment terms.
Using WCR for growth
The low-interest-rate environment has allowed businesses to benefit from a working capital loan with attractive terms to upgrade their facilities, invest in upcoming projects, or acquire companies to ensure future profitability.
Bring in expert trade and risk analysis before making the investment move to ensure that you’re not being too aggressive due to FOMO (fear of missing out) or being too conservative. A country’s recovery could also differ from another.
Trade credit insurers, for instance, can provide advice and help you make better-informed decisions. Your company will manage its working capital needs, develop a forward-looking view, and ensure future growth by determining the working capital requirements and understanding any changes.