How To Use Working Capital Management Effectively

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Working capital management is how a business oversees short-term assets such as cash and accounts receivable, along with short-term liabilities like interest due on loans and accounts payable. When done well, it helps a business meet its current obligations and keep enough capital available to operate and grow.

Effective working capital management can help a business withstand market shifts or economic shocks. That matters because many small businesses struggle to stay afloat. According to the US Bureau of Labor Statistics, a fifth of small businesses fail within their first year, and only about half make it to the five-year mark.

Read on to learn about the core components of working capital management, the key performance indicators (KPIs) that reflect financial health, and tips for managing your working capital effectively. 

What is working capital management?

Working capital management means balancing a business’s short-term uses and sources of money. Working capital refers to the funds a business uses for day-to-day operational needs such as paying suppliers, employees, expansion, acquisition, or new product development.

Working capital, also called net working capital, is the difference between current assets and current liabilities. Current assets include cash, accounts receivable, and inventory, as well as any assets that can be converted into cash within a year, such as marketable securities.

Current liabilities, which include accounts payable and other short-term debt, are obligations due in the same period. Current liabilities are compared with current assets to see if working capital is increasing or decreasing, and whether a business’s cash cushion for meeting expenses and short-term obligations is expanding or shrinking.

You can calculate working capital using the following formula:

Working capital = current assets – current liabilities

If you have negative working capital, it means the business lacks the available funds to cover its short-term financial obligations, which means it may have trouble paying suppliers, creditors, and employees.

Working capital vs. cash flow

Cash flow and working capital are related, but they measure different things. Cash flow tracks the amount of cash moving in and out of the business during an accounting period. Working capital measures whether a business has enough current assets to cover current liabilities. Working capital includes non-cash current assets that can be converted to cash, such as inventory and accounts receivable. 

A business has positive working capital if it has enough cash and other current assets to pay its current liabilities, which include operating expenses and short-term debt.

Core components of working capital 

• Cash and equivalents
• Accounts receivable
• Inventory
• Accounts payable
• Accrued expenses
• Short-term debt

Current assets and current liabilities are listed on a business’s balance sheet, one of the three main financial statements along with the income statement and cash flow statement. The balance sheet lists assets by category in order of liquidity, or how quickly they can be converted to cash. It also lists liabilities by category, with current liabilities first followed by long-term liabilities.

Key components of working capital include:

Cash and cash equivalents

Cash is immediately available in bank accounts. Cash equivalents are very liquid short-term investments, such as three-month US Treasury bills, 90-day bank certificates of deposit, and commercial paper. Because they can be sold quickly, and tend to hold their value, they are a business’s quickest and most reliable source of cash.

Accounts receivable

Accounts receivable is money owed to the business, including payments due from customers who buy on credit and are expected to be paid within a set period, such as 30 days from purchase. Cash from receivables depends on how quickly customers pay.

Inventory

These are goods your business has purchased and plans to sell, as well as raw materials for production. The faster you sell inventory, the faster you can turn into cash flow and boost your working capital position. Slow sales tie up cash flow in unsold goods and can weaken working capital.

Accounts payable

Accounts payable is how much money a business owes to suppliers, contractors, and other third parties. Other current liabilities that could be considered accounts payable include unpaid vendor invoices for goods and services already received.

Accrued expenses

Accrued expenses are another current liability. They are operating costs incurred but not yet paid.

Short-term debt

Debt obligations include principal and interest on short-term debt due within a year or less, as well as the interest portion of long-term debt.

Key performance indicators for working capital

• Current ratio
• Quick ratio
• Inventory turnover ratio
• Days sales outstanding
• Cash conversion cycle
• Working capital turnover ratio

The amount of working capital and cash flow your business has on hand can affect its ability to cover short term obligations. Use these performance indicators (KPIs) for working capital management to measure liquidity and financial health:

Current ratio

Also called the working capital ratio, this is calculated by dividing current assets by current liabilities. It’s the most commonly cited indicator of working capital. 

For example, say that a business’s current assets for the year are $2 million, and current liabilities are $1 million. Its current ratio is 2:1, or 2. A breakeven ratio of 1:1 means that for each dollar of short-term obligations, a business has one dollar of cash or other assets available to pay financial obligations. 

Lenders review the current ratio when considering a business loan, and regulators monitor publicly traded companies’ current ratios in their periodic financial statements. 

Quick ratio

This is sometimes called the acid test ratio, and is a stricter measure than the current ratio. It excludes inventory as a current asset because stock may take longer to sell, and its value may decline. The quick ratio is calculated by subtracting current assets minus inventory, then dividing that figure by current liabilities. Say the business above has inventory of $500,000 at year-end. Its quick ratio would be:

($2 million - $500,000) / $1 million = 1.5

Inventory turnover ratio

This shows how many times a business sells and replaces its inventory in a period, typically a year. A high inventory turnover ratio points to healthy sales and lean inventory management, while a low ratio can signal overstocking or unpopular products. Comparisons with competitors, industry norms, or internal benchmarks can help determine an appropriate turnover ratio. 

The formula for the ratio is cost of goods sold (COGS) in a period, divided by average inventory value. Let’s say the business above had a COGS of $2.5 million for the year, and inventory with an average value of $500,000. Its turnover ratio would be:

$2.5 million / $500,000 = 5

Days sales outstanding

Days sales outstanding (DSO) tracks the average time a business waits to collect payment from customers who bought on credit. Fewer days outstanding, generally means stronger working capital and cash flow. 

To calculate DSO, divide accounts receivable by total credit sales in the period, then multiply by the number of days in the period. For example, if the above business had $250,000 in accounts receivable and $2 million in credit sales for the year, its days sales outstanding would be:

($250,000 / $2 million) x 365 days = 45 days

Cash conversion cycle

The cash conversion cycle (CCC) tracks the time it takes a business to sell its inventory, collect payment on its accounts receivable, and pay its bills. A shorter conversion cycle means a business is getting cash back quicker to pay bills and to invest in growth. A longer conversion cycle might suggest the business is having trouble paying current obligations and might require external financing to cover the gap.

It involves three metrics: days inventory outstanding (DIO), days sales outstanding (DSO), and days payable outstanding (DPO). Calculate CCC using the following formula:

CCC = DIO + DSO − DPO

Calculating the conversion cycle requires three preliminary calculations. 

DIO = (Average Inventory ÷ Cost of Goods Sold) × 365

DSO = (Accounts Receivable ÷ Net Credit Sales) × 365

DPO = (Accounts Payable ÷ Cost of Goods Sold) × 365

Let’s say a business has a DIO of 73 days, a DSO of 45 days, and a DPO of 60 days. The cash conversion cycle is:

73 days + 45 days - 60 days = 58 days 

Working capital turnover ratio

This ratio, also called net sales to working capital, shows how much sales revenue a business generates for each dollar of working capital. To calculate, take sales for a period and divide that by average working capital. Using the example above, let’s say the business has $5 million in sales for the year and average working capital of $1 million. Its working capital turnover ratio is:

$5 million/$1 million= 5

Tips for effective working capital management

• Speed up customer payments
• Negotiate more favorable payment terms with suppliers
• Improve inventory management
• Improve cash flow forecasting
• Use short-term financing

Businesses may use certain strategies to strengthen working capital, including:

Speed up customer payments

The quicker customers pay, the better your cash flow, which supports working capital. You can speed up customer payments by:

• Sending invoices as soon as service or delivery is complete

• Shortening payment terms, such as reducing them from 60 days to 30 days

• Offering early payment incentives, such as 2/10 net 30—which grants a 2% discount if the invoice is paid within 10 days instead of the full 30 days

• Automating invoices and billing with reminders to customers and following up with overdue accounts regularly

Negotiate more favorable payment terms with suppliers

Your goal is to balance your cash outflows with inflows, so you can hold on to cash longer. Some ways to manage your accounts payable include:

• Waiting until payment is due before paying invoices

• Asking suppliers for longer terms, such as 45 days instead of 30

• Seeking early payment discounts

• Using automation to schedule payments and avoid overdue notices and late-payment penalties

Improve inventory management

Inventory represents money tied up in goods you haven’t yet sold. Faster turnover means more cash coming in. More efficient inventory management might involve:

• Using a just-in-time restocking with suppliers, to avoid overstocking or stockouts

• Liquidating slow-moving items

• Tightening your safety stock buffer; keep just enough to avoid running out and disappointing customers

• Fine-tuning your demand forecasting. Track inventory turnover to see which products sell fastest, and reorder accordingly

Improve cash-flow forecasting

Improve cash-flow forecasting by:

• Accounting for seasonal sales fluctuations using historical sales data

• Setting up reminders for less frequent obligations, such as quarterly estimated tax deadlines and annual tax payments

• Reviewing overdue customer balances to assess which accounts to pursue and which may be uncollectible 

Use short-term financing

If appropriate for your situation, a short-term loan or cash advance can keep operations running when your business has a working capital shortfall. You can use short-term credit for:

• Purchasing inventory in anticipation of strong seasonal sales

• Covering immediate needs such as payroll and utilities

• Bridging cash shortfalls caused by seasonal slowdowns and late customer payments

• Funding growth initiatives when the expected return outweighs the financing cost

Shopify Capital can provide loans and cash advances to cover gaps in working capital. For example, Shopify Capital flex accounts offer credit for various working-capital needs and seasonal cash flow swings, letting businesses draw funds as needed up to their borrowing capacity.

*All loans through Shopify Capital Loans are issued by WebBank. Offers are subject to change based on several factors including your store's performance and the review of your financial information. Shopify Capital Loans must be paid in full within 18 months, and two minimum payments apply within the first two six-month periods. Offers to apply do not guarantee funding. Repayments are made based on a percentage of daily sales.