How working capital can improve your company’s liquidity

Liquidity is the lifeblood of every business. Without enough liquid assets, even a thriving company can experience financial strain. Making it harder to cover daily operating expenses or react to unexpected challenges. For financial executives, small business owners, and entrepreneurs, one critical metric serves as a gauge for short-term financial health—working capital.

But what exactly is working capital, and how can it be leveraged to improve liquidity for your business? This guide will break down the components, types, and strategies for optimizing working capital, ensuring you can maintain operational efficiency and seize growth opportunities.

What is Working Capital?

At its core, working capital is the difference between a company’s current assets (i.e. cash, accounts receivable, and inventory) and current liabilities (i.e. accounts payable and short-term debts). It is a financial indicator of a company’s capacity to meet short-term obligations, maintain business operations, and survive periods of uncertainty.

The Formula for Working Capital:

Working Capital = Current Assets - Current Liabilities

A positive working capital indicates a business has more assets than liabilities, signaling a strong liquidity position. Conversely, negative working capital could imply issues with cash flow or potential insolvency.

Why is Working Capital Important for Liquidity?

Liquidity measures how easily a company can convert its assets into cash to cover immediate expenses. Working capital serves as a direct indicator of liquidity and can inform business decisions such as inventory purchases, payroll management, and capital investments.

By actively managing working capital, businesses can:

• Conserve cash reserves to handle day-to-day expenses.

• Avoid relying on costly funding options like emergency credit lines.

• Meet obligations to suppliers, employees, and creditors promptly.

• Invest in growth opportunities without stretching financial resources.

Now, let's investigate the key elements of working capital and how they affect liquidity.

Components of Working Capital

As mentioned above, working capital consists of current assets and current liabilities. Each component plays a crucial role in shaping your company's liquidity.

Current Assets (Resources Available Within a Year)

1. Cash and Cash Equivalents

Easily accessible funds, including cash in hand, bank balances, and short-term investments like money market funds or treasury bills. These are a company’s most liquid assets, ensuring smooth operations.

2. Accounts Receivable (AR)

This is the money customers owe your business for products or services you’ve already delivered but haven’t been paid for yet. Accounts receivable (AR) is a major component of your company’s working capital and appears as an asset on your balance sheet. Managing AR well is extremely important—it keeps cash flowing smoothly, allows you to cover daily operations, and increases overall financial flexibility. On the other hand, deficient AR management can result in cash flow problems, making it harder to pay bills or re-invest in growing your business.

3. Inventory

Inventory is basically the unsold stuff—raw materials, products in progress, or finished goods ready to sell. It’s a big deal because businesses rely on it to satisfy customer demand and generate revenue. However too much inventory can cause problems. It ties up cash that could be used elsewhere in a business, which might lead to financial headaches.

Plus, extra inventory represents higher storage costs, and the possibility items might become outdated. That’s why managing inventory efficiently is so important—it helps keep a good balance between the supply and demand of inventory, while avoiding unnecessary costs.

4. Marketable Securities

Short-term investments, like stocks, bonds, or money market instruments, are great options if you’re wanting to grow your money while ensuring it is easy to access. They’re ideal for when you need a temporary spot for your cash but need the flexibility to access it quickly. Whether it’s for an unforeseen expense or a short-term goal, these investments can offer you that extra financial cushion when you need it most.

5. Prepaid Expenses

Prepaid expenses are payments you make upfront for things like rent, insurance, or subscriptions. They’re recorded as assets on the balance sheet until you in fact use the services over time.

While they’re important for guaranteeing services or coverage, they don’t help much with short-term cash flow given you can’t easily convert them into cash. So, even though they’re important for long-term planning, they don’t do much to enhance a company’s ability to handle immediate financial needs.

Current Liabilities (Obligations Due Within a Year)

1. Accounts Payable (AP)

Accounts payable is what a business owes to its suppliers for purchases made on credit—in other words, unpaid invoices for goods or services already received. Managing these payments on time is crucial in maintaining good relationships with suppliers, avoiding late fees, and maintaining a good credit history.

But there’s also a balance to strike—you need to make these payments while maintaining enough cash on hand to cover other expenses and unexpected costs. It’s all about staying liquid and ready for whatever comes your way!

2. Short-term Debt

Loans or borrowings that are due within a year are accounted for as short-term liabilities on your balance sheet. They typically come with terms like repayment schedules, interest rates, and penalties for late payments. If these liabilities aren’t properly managed, they can materially impact your cash flow, making it harder to pay suppliers, employees, or even long-term debts. That type of strain could put your business at risk.

3. Accrued Liabilities

Unpaid expenses like wages, taxes, and interest are bills your business owes but hasn’t paid yet. Managing these appropriately is vital to keeping things running smoothly and avoiding unexpected cash crunches. Keeping on top of these payments isn’t just about following the rules—it’s also about fostering trust with your employees, creditors, and stakeholders.

4. Deferred Revenue

When customers pay you upfront for goods or services, it means you’re receiving the money before delivering what’s promised. It’s a fantastic way to boost cash flow and cover your expenses early. However, it’s important to manage this money wisely—you’ll need to have enough resources, inventory, or capacity to follow through later. If you don’t deliver, you risk unhappy customers, damage to your reputation, and even refund demands.

Optimizing things like inventory management, accounts receivable, and accounts payable can help you develop a solid working capital strategy. This not only boosts your cash flow but also offers your business the flexibility to cover short-term needs and capitalize on growth opportunities.

Strategies to Improve Working Capital and Liquidity

Now that we’ve covered the basics of working capital and its types, let’s talk about how to apply it to your business. Managing your working capital the right way means better cash flow, smoother operations, and setting your business up for success in the long term. Here are some simple tips to help you get the most out of your resources:

1. Monitor Accounts Receivable

Managing your accounts receivable (AR) effectively is key to keeping cash flowing smoothly into your business. Here’s how you can make it happen:

• Send out invoices as soon as possible. This keeps the payment process moving and gives your customers plenty of time to pay.

• Offer discounts for early payments. It’s a great way to incentivize customers to pay sooner while building goodwill and improving your cash flow.

• Remain on top of overdue payments with a solid follow-up system i.e. fully leverage your CRM (“Customer Relationship Management”) or introduce a CRM to assist you. Friendly reminders, phone calls, or emails can help make sure you get paid on time and avoid bad debt.

2. Manage Accounts Payable Strategically

Try to extend payment terms with suppliers. This can materially improve cash flow but do it thoughtfully and respectively. Strong supplier relationships are pivotal for long-term success. If your suppliers offer early payment discounts, take a close look and weigh whether the savings are worth it compared to maintaining sufficient cash on hand for other needs. It’s all about striking the right balance to keep both your finances and partnerships in good shape.

3. Optimize Inventory Levels

Holding onto too much inventory? It’s like tying up cash that could be deployed to better use in your business. Don’t worry, here are a couple of tips to help:

• Forecast demand: Examine your past sales, market trends, and seasonal patterns to keep your stock levels balanced. That way, you’ll have what you need without overloading your shelves.

• Try just-in-time (JIT): With this method, you only order inventory when you need it. It’s a smart way to save on storage costs and avoid stock obsolescence.

4. Invest in Technology

Take advantage of tools like cash flow forecast software or ERP systems to get a better handle on your working capital. These tools make it easier to track important activities such as receivables, payables, and inventory levels by automating the process. Additionally, automation reduces human error and provides you with real-time updates on your liquidity, so you can make faster, smarter financial decisions. Employing these tools can streamline your operations, boost accuracy, and take your financial strategy to the next level.

5. Secure Short-term Financing When Necessary

If you’re experiencing cash flow gaps, establishing credit lines or using invoice factoring can be a real lifesaver. These options offer you quick access to funds when you need them most, keeping your business running smoothly without any interruptions. With these tools in your back pocket, you can manage short-term challenges and remained focused on growing your business for the long haul.

6. Evaluate Revenue and Expense Cycles

Examine closely your profit margins to identify areas where you can improve and keep your business in good financial shape. Eliminate unnecessary expenses by reviewing your operational costs and explore ways to streamline processes. Ensure your cash outflows equate with your inflows to maintain smooth operations and build long-term financial stability.

Next Steps for Businesses

Managing working capital isn’t just about keeping your books in order—it’s about setting your business up for long-term success. By continuing to monitor your assets and liabilities, you can ensure there’s sufficient cash on hand to cover short-term needs while conducting advanced planning for future growth. Implemented successfully, it boosts cash flow, increases liquidity, and builds trust with important partners like suppliers and investors by showing you’re financially trustworthy. In addition, good working capital management can provide access to new opportunities, whether it’s expanding your business, driving innovation, or staying ahead of the competition.

At Strategize Financial Modeling, we work closely with financial executives, entrepreneurs, and small business owners to evaluate their working capital needs and implement tailored strategies for success. Whether you’re struggling with cash flow challenges or looking to optimize your operations, our team is here to help.

Want to transform your company’s financial health today? Schedule a consultation with our experts to learn how we can help you enhance liquidity and drive growth.