A healthy working capital is vital for any business. When you are short of working capital, you can run into problems paying day-to-day expenses. A healthy working capital is therefore often thought to mean: the more, the better, yet this is not entirely true. In fact, you can have excess working capital. So what is healthy working capital and how do you ensure it? We will explain that to you in this blog!
What is working capital?
Before we look at what healthy working capital is, it is good to take a look at working capital in general. Because what exactly is working capital?
Simply put, working capital is the money a company sets aside to pay for day-to-day expenses. What can you think of in terms of these costs? Paying suppliers, paying salaries to staff and replenishing the company’s stock, for example. All the money you set aside to pay for these costs is classified as working capital. Yet not all costs fall under working capital. For example, do you want to invest in machinery, company cars or other business assets to help your business move forward? Such investments are not paid for from working capital.
What is healthy working capital?
A healthy working capital is important for any business. To be able to pay all daily expenses, it is very important to have sufficient working capital within a business. When this is not the case, it can create unpleasant financial situations for a company. It is therefore very important that sufficient working capital is set aside at all times to meet these payments. But as we briefly mentioned, too much of it is also not desirable.
You might think: the bigger the working capital, the better. Surely more money within a company can never be a bad thing? This is partly true, but in the case of working capital, there is one obvious caveat: it is money that does not bring a company anything. After all, working capital is meant for things like salaries and stocks. So it cannot be used to invest or put in the bank to receive interest on it. Often, excess working capital is money tied up in accounts receivable or (too ample) inventories. Of course, it is always better to have too much than too little working capital, but a really healthy working capital is all about balance.
Do I have healthy working capital?
Want to check whether you currently have a healthy working capital? The cash conversion cycle (CCC) plays an important role here. This is because this cycle indicates how much time a company needs to convert products – both purchased and produced – into cash. This is very important information when you want to see if you have a healthy working capital, because the longer the cycle takes, the more money is tied up in your business as working capital for a longer period of time. You calculate the CCC in the following way:
CCC = DIO + DSO – DPO
Days Inventory Outstanding (DIO)
DIO (Days Inventory Outstanding) revolves around the average number of days after which a company converts its inventory into cash. After all, money stuck in a company in the form of inventory cannot be invested.
Days Sales Outstanding (DSO)
DSO (Days Sales Outstanding) describes the average number of days your invoices sent are outstanding. Do you supply a product or service for which you send invoices? Then, of course, you want your customers to pay the invoice as soon as possible. Yet unfortunately, this is not always the case, which can have unpleasant consequences for a healthy working capital.
Days Payable Outstanding (DPO)
The DPO (Days Payable Outstanding) shows how quickly a company pays its creditors. This also plays an important role in determining the CCC and thus optimising working capital, because the longer it takes for suppliers to get paid, the more money a company keeps as working capital.
How do you create healthy working capital?
When you want to create a healthy working capital, there are a number of things you can do as a company. Here again, it is good to keep the aforementioned cash conversion cycle (CCC) in mind.
For example, to keep the DIO as low as possible, it is important that the inventory is well aligned to the needs of the current market. When setting up stock, it is therefore a good idea to research this and adjust stock accordingly. This way, you avoid being stuck with large stocks of unsold items.
It is also important, when creating a healthy working capital, that the invoices you send are paid as soon as possible. Are you generally waiting a long time for your invoices to be paid? Unfortunately, there is nothing you can do about this on your end, as you are mainly dependent on the customer. However, there are some things you can optimise to try and reduce this time as much as possible. For instance, how is the communication with the customer? Are the invoices drafted clearly enough? Are the invoices sent quickly enough? When you optimise these aspects for yourself, you can be sure that you can’t blame yourself in this. At such a point, is there nothing more you can do on your side to receive the money from the invoices in question faster? Yes, there is: factoring, for example.
A healthy working capital with factoring
Despite optimising the invoicing process on your side, are you still dealing with invoices that are paid late or not at all? Then this can cause you to run into problems creating a healthy working capital, because for that you also depend on payments from debtors. Fortunately, you can use factoring at such times. This is because with factoring, you can be sure at all times that the money from invoices sent will reach your account on time. Ideal, right? But what is factoring and how does factoring actually work?
Factoring is all about selling invoices. Here, you sell the invoices to a factor – for example Factris – which in turn ensures that you receive the corresponding amount in your account within 24 hours. When you use factoring, you are no longer dependent on customers who pay (too) late, so you are always assured of healthy working capital. Factris takes care of the financial settlement with the customer after buying out the invoices. We arrange for the outstanding amount to be collected from the customer, so you do not have to worry about this.