What is Working Capital?
Working capital = Current assets - Current liabilities. It represents the cash and liquid assets available to run day-to-day operations. Positive working capital means you can pay bills; negative means cash crunch risk.
Components: Current assets include cash, accounts receivable, inventory, prepaid expenses. Current liabilities include accounts payable, short-term debt, accrued expenses, payroll liabilities.
Why it matters: Even profitable companies can fail due to poor working capital management. You might have ₹50L in receivables but only ₹5L cash - can't pay salaries with invoices!
Cash Conversion Cycle
The cash conversion cycle (CCC) measures how long cash is tied up in operations before converting back to cash. Lower CCC = better cash efficiency.
Formula: CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payables Outstanding (DPO).
Example calculation:
- DIO = (Average inventory / Cost of goods sold) × 365 = (₹20L / ₹100L) × 365 = 73 days
- DSO = (Average receivables / Revenue) × 365 = (₹15L / ₹120L) × 365 = 46 days
- DPO = (Average payables / Cost of goods sold) × 365 = (₹10L / ₹100L) × 365 = 37 days
- CCC = 73 + 46 - 37 = 82 days
Interpretation: Cash is locked in operations for 82 days. To optimize, reduce DIO and DSO while increasing DPO (without damaging supplier relationships).
Optimizing Accounts Receivable
Strategies to collect faster:
- Invoice immediately: Send invoice same day as delivery/service completion. Delay = delayed payment.
- Clear payment terms: Specify due date, payment methods, late fees upfront. Include in contracts.
- Offer early payment discounts: 2% discount for payment within 10 days (2/10 Net 30 terms). Costs less than borrowing.
- Automate follow-ups: Email reminders at 7 days before due, due date, 7 days overdue, 15 days overdue.
- Multiple payment options: Net banking, UPI, credit card, NEFT. Remove friction from payment process.
- Credit checks on customers: Before offering credit terms, check their payment history. High-risk customers = advance payment only.
- Aging analysis: Weekly review of receivables >45 days. Personal follow-up from founders for large amounts.
- Consider factoring: Sell invoices to factoring company at discount for immediate cash (expensive but useful in crisis).
Target DSO: B2B SaaS: 30-45 days. E-commerce: 0-7 days. Manufacturing: 60-90 days. Compare against industry benchmarks.
Managing Inventory Efficiently
Inventory ties up cash. Goal is to minimize inventory while maintaining service levels (no stockouts).
Techniques:
- ABC analysis: Classify inventory by value. A items (high value, 20% of SKUs, 80% of value) = tight control. C items (low value) = looser control.
- Just-in-time (JIT): Order inventory only when needed. Requires reliable suppliers and accurate demand forecasting.
- Economic Order Quantity (EOQ): Calculate optimal order quantity that minimizes ordering + holding costs.
- Safety stock optimization: Maintain minimum buffer for demand variability, not excess 'just in case' stock.
- Demand forecasting: Use historical data + market trends to predict demand. Adjust inventory levels accordingly.
- Supplier consolidation: Fewer suppliers = better negotiation power, bulk discounts, lower minimum orders.
- Dropshipping (e-commerce): Don't hold inventory at all. Supplier ships directly to customer.
- Consignment inventory: Supplier owns inventory until you sell it. Zero working capital impact.
Target DIO: E-commerce: 30-60 days. Manufacturing: 60-120 days. Fast-moving goods should turn over faster than slow-moving.
Payables Management Strategy
Pay suppliers as late as contractually allowed (without damaging relationships or credit). This keeps cash in your business longer.
Best practices:
- Negotiate extended terms: Ask for Net-60 or Net-90 instead of Net-30, especially with large vendors.
- Time payments strategically: Pay on the last day of terms. If due on 30th, don't pay on 15th.
- Prioritize payments: Critical suppliers first, then by due date, then by discount opportunity.
- Take advantage of discounts selectively: Only if discount % > your cost of capital. 2% for 10 days early on Net-30 = 36% annualized return.
- Use corporate credit cards: Gives you 30-45 days float + rewards points. Pay off full balance monthly.
- Consolidate purchases: Larger orders = better negotiating leverage for terms and discounts.
- Build supplier relationships: Good relationships = more flexibility during cash crunches.
- Automate payment scheduling: Schedule payments for due date, not before. Prevents early payments.
Warning: Don't delay payments to the point of damaging credit or supplier relationships. Late fees and supply disruptions cost more than the float benefit.
Measuring Working Capital Health
Key metrics to track monthly:
- Current ratio = Current assets / Current liabilities. Healthy range: 1.5-3.0. <1 = liquidity crisis.
- Quick ratio = (Current assets - Inventory) / Current liabilities. More conservative. Healthy: >1.0.
- Cash conversion cycle: Track trend. Target: reduce by 10-20% year-over-year.
- Working capital turnover = Revenue / Average working capital. Higher = more efficient use of working capital.
- DSO trend: Should decrease or remain stable. Increasing DSO = collection problems.
- DPO trend: Should increase without supplier issues. Decreasing = losing negotiation leverage.