Why You Must Manage Working Capital
Working capital, also referred to as operating capital, represents the value of liquid assets such as cash and accounts receivable that are readily available to cover operational costs and service debt. Since business conditions can be unpredictable, it is wise to have a cushion set aside to cover unanticipated expenses, in addition to the cash required to cover regular monthly obligations. Here are some of the reasons why this is one of the most critical aspects of your business and why you must manage it carefully.
Consider the fact that there are business expenses such as payroll, taxes, and other operating costs that must be covered, regardless of when your customers pay you. Occasionally, customer payments are delayed. However, you still need to be able to meet your expense obligations, so healthy operating capital should be adequate to cover at least a month’s worth of operating costs, in addition to a comfortable reserve.
Working capital covers timing differences between when money goes out and when it comes in. For example, accounts receivable invoices typically have 30-day payment terms. However, if you have a large client representing a significant percentage of your monthly revenue, your cash flow might be in big trouble if payment from them is delayed.
Periodically, expenses may arise that you haven’t considered in your monthly budget. For example, even minor litigation could cost tens of thousands of dollars in legal fees. Make sure that your company has the reserves to cover these unexpected expenses without derailing your operating budget.
New Company Initiatives
If your company is about to embark upon a new line of business or a project that requires additional staffing, chances are there will be many expenditures before the new revenue starts coming in. It means that for a time, you will need to have sufficient operating capital to cover not only the regular monthly operating costs but the additional expenses as well.
The basic accounting definition of insolvency is when a company’s liabilities exceed its assets. If you allow your working capital to go unmanaged, it is a situation you might find yourself in, and one that it is not sustainable.
A financially healthy business has ready access to enough cash to cover monthly expenses and maintain an adequate cushion to cover cash flow timing issues and unexpected costs. Without proper management of operating capital, your company could find itself in a difficult situation or even become insolvent. The good news is that these problems can be avoided by careful management of operating funds.