How is Working Capital Improvement Calculated?
In its simplest form, working capital provides a snapshot of how much your current assets exceed your current liabilities. Every business can benefit from understanding how working capital is calculated in order to learn if you have enough money to meet current expenses. The working capital ratio formula to determine financial health is:
Current Assets/ Current Liabilities
A result less than one can indicate there is not enough working capital to meet expenses and manage liabilities. A result greater than 1.5 shows working capital improvement.
Working Capital Improvement Techniques
Making cash flow more predictable in order to fuel your operating cycle for growth can seem easier said than done. These working capital improvement techniques can help.
1. Shorten Operating Cycles
An increased cash flow generates working capital. One way to increase cash flow is to shorten your operating cycle – the process of converting money tied up in production and sales into cash. The longer this process takes, the higher the likelihood of non-payment and the greater impact to your working capital.
Options to shorten your operating cycle and generate working capital faster can include asking for deposits or upfront payment, reducing credit terms and billing as soon as a sale is made. You can also take a harder look at sales forecasting and demand planning, as well.
2. Avoid Financing Fixed Assets with Working Capital
Every business owns or intends to own fixed assets such as buildings, equipment, vehicles or land. These assets are used to generate long-term growth. While selling a fixed asset can boost cash flow and working capital, financing a fixed asset with working capital is never a good idea. Fixed assets tend to be expensive and paying for them not only depletes working capital but increases the risk profile that financial institutions use to determine creditworthiness. A better strategy is to use long-term loans or a lease to finance fixed assets.
3. Perform Credit Checks on New Customers
Before you take on a new client or extend credit, do some research into the prospect’s creditworthiness. This due diligence will help you improve your trade working capital by indicating if a new client is likely to default on payment or pay you on time. Reviewing the new client’s credit report can be helpful. These reports include information from public records about credit history, bankruptcies, or tax liens as well as some payment history. But credit report data becomes obsolete quickly and may not provide a true picture of a client’s or prospect’s current fiscal health.
Equally important in assessing a client’s credit risk is understanding their industry and local market. If you are working with clients in foreign markets, it can be difficult to weigh the economic, political and business risks unique to a specific country. Taking advantage of a risk expert’s knowledge and risk analysis can help protect you against credit risk in international trade. Euler Hermes understands that if you are a multinational company, your financial structures are complex. Our experienced international risk experts can provide you reliable information and help in your credit risk research.
4. Utilize Trade Credit Insurance
A very effective way to increase net working capital is to purchase accounts receivable insurance (also known as trade credit insurance). Trade credit insurance acts as a safety net to protect your business from non-payment of your accounts receivable. This frees you from maintaining bad debt reserves and helps you protect your capital, maintain your cash flow and secure your earnings while extending competitive credit terms to your customers.
Trade credit insurance can also help companies secure working capital financing. Banks usually limit what you can borrow against your receivables because of the perceived risk. But banks consider receivables insured by trade credit insurance as secured collateral. This often means they will lend more money at a lower interest rate to companies that have trade credit insurance.
Trade credit insurance from Euler Hermes includes an additional feature that helps support healthy working capital: risk data. Accessing this data can help businesses increase their net working capital via improved credit control, avoiding bad debt and safely expanding sales to new and existing customers.