Imagine you are running a company that generates profits but struggles to meet its short-term financial obligations when they become due. This dilemma is common in a lot of businesses, and the leading cause is the poor management of the business’ working capital. Jason (2025) highlights that Working capital is the difference between the business’s current assets, like cash at hand and banks, debtors, and stock and its current liabilities, like a bank overdraft and creditors. A business is able to meet its short-term obligations, channel its funds to emerging opportunities, and fund its daily operations when it has efficiently managed its working capital. This article will dive into the working capital of the business and how it can be optimized, leading to efficiency in the business operations.
Understanding the Working Capital
Working capital takes two forms, which include:
- Gross working capital- refers to the total value of the current assets available in the business. It includes goods ready to sell, customer debt, and cash. Gross working capital is mainly used to show the amount of resources available to run the business in the short term.
- Net working capital- the difference between the current assets and current liabilities.
A business can only have either positive or negative net working capital. Good financial health and the ability to easily service its short-term obligations when they fall due is shown when a business has a positive net working capital. Even so, the positive net working capital is perceived to be good; it can indicate that the business’ resources are underutilized. On the other hand, a negative net working capital means that a business will be struggling to meet its short-term obligations when they fall due. It is not a good sign for the business as it can lead to inefficiency in business operations.
Cash Conversion Cycle
This is an essential key performance indicator used to evaluate a business’s working capital management. It mainly measures the duration taken by an entity to convert its investment in inventory and other inputs into cash from sales. Below is the formula to calculate the cash conversion cycle.
Cash conversion cycle = (Days inventory outstanding + days sales outstanding) -days payable outstanding
Days inventory outstanding usually measures how long the inventory takes before it is sold. Days sales outstanding measure the period it takes for a business to collect the payment made after sales. Days payables outstanding measure how long it takes a business to pay its suppliers.
A business needs a lower cash conversion cycle, which indicates that it can convert its investments in inventory into cash rapidly. Thus, the business uses this money to pay for expenses of its daily operations, resulting in stronger liquidity. The lower capital conversion cycle will also enable the business to avoid a lot of borrowing and reinvest its money quickly.
Why Optimizing Working Capital Matters
Optimizing working capital is far more than a financial best practice; it is a critical strategic plan that influences a company’s stability, profitability, and capacity for growth. When managed effectively, working capital transforms from a passive line item into a powerful tool for driving performance. Research done by inspired economists (2023) highlights that optimizing the working capital has the following significance.
Enhanced Liquidity Management
A business that has optimized working capital ensures that there is enough money for the company to meet its current liabilities when they fall due instead of borrowing from outside. This cash reserve is essential as it enables smooth operations, for instance, during periods of economic downturn. During this time, the business is not making a lot of sales, so an optimized working capital can help it navigate through the uncertainty that is involved during this period.
Reduction of Financial Costs
Effective optimization of working capital will ensure that the business can have enough cash to fund its operations by enabling enhanced inventory management, accelerating receivable collection periods, and extending the payables periods, thus reducing dependence on external short-term borrowing. This clearly shows that an optimized working capital can help a business reduce the cost incurred to acquire short-term loans like legal and application fees, as well as the amount of interest expense charged on the borrowed funds.
Improved Profitability
Efficient working capital management enables a business to free up underutilized capital, which is then reinvested in high-return investments, such as entering new markets and enhancing business processes and operations. Additionally, as the business reduces the amount of borrowing to meet short-term needs, the amount of money paid to service its debts reduces, increasing the profit because the interest paid expense reduces.
Operational Flexibility
Optimized working capital helps a business be strategically ready to respond to market challenges, such as changes in market trends, changes in customer needs and sudden interruptions. Ensuring quick access to cash can help a business plan make faster procurement decisions before the stock is finished, invest in new opportunities promptly when they arise and adapt to sudden changes in market demands and trends. This flexibility enables a business to be competitive in the market and meet long-term goals.
Improved Stakeholders Relationships
An operating business has key stakeholders, such as customers and suppliers, who facilitate its operations. The relationships between the business and the key stakeholders will be improved when the entity has efficient working capital. When the business’s suppliers are paid on time, this improves the relationships, increases trust and leads to better payment terms in the future; on the other hand, when a business collects account receivables on time and ensures that the goods are available for the customers, it improves customer relationships, hence satisfaction.
Strategies to Optimize the Working Capital
In a rapidly changing economic environment, an optimized working capital is crucial. A lot of entities find it hard to optimize their working capital. Below are the strategies a company needs to implement to ensure that it has optimized its working capital, as per Henry (2024):
Ensure Accounts Receivable are Streamlined
This strategy of working capital optimization aims to ensure efficiency in how the business collects its debts. The company needs to immediately send an invoice to the customers when the goods have been received by the client so that the payment cycle is reduced. The business also needs to look for a solution to mitigate the bad debt risk. Before new customers are given goods on credit, a creditworthiness review needs to be done by the business so as to know if the customer is creditworthiness or not. An entity needs to encourage earlier payment by providing customers with discount offers when they pay in advance so as to promote quick payment and enhanced cash flow. Additionally, the business leverages technology to have automatic reminders for making follow-ups so as to reduce the amount owed by customers.
Efficient Management of Inventory
A lot of working capital is being tied up in the inventory; thus, poor inventory management will lead to difficulty in working capital efficiency. A business can easily optimize its inventory using two methods:
- Just-in-time method- This method ensures that the business only procures goods when they are needed. It helps ensure inventory efficiency and reduces storage expenses and wastage. Additionally, it mitigates risks like obsolete and holding costs, thus leading to improved cash flow.
- Economic order quantity- This method helps a business decide on the amount of goods it is supposed to order from the supplier and when to buy them. It thus helps reduce the total cost of inventory and ensures inventory efficiency, as overstocking and stock depletion are avoided.
Using the above two methods, a business can have the required quantity of goods at a particular time, and the goods will be right for the customers. Thus, the goods will be converted to cash easily without wastage, providing money that the business will use to meet its daily obligations, hence optimizing working capital.
Manage Accounts Payable Strategically
When a business pays suppliers and creditors, it reduces the amount of funds available to meet daily operations. A business should then look for ways of extending the period taken before paying the suppliers but be careful to avoid damaging the relations and avoid penalties. A company should look for creditors who are flexible and can arrange more extended payment periods. Comparisons also must be made by the business for the discount received on cash payment so that a better decision can be made on the mode of payment. Additionally, payment schedule tools should be implemented so that the payments that are due are being planned early to avoid late fees.
Enhance Operational Cost Efficiency
Reducing a business’s operational costs is another way of ensuring optimized working capital. A business needs to conduct regular audits to identify unnecessary costs and inefficient processes and remove them. By doing this, the company can reduce the amount of money incurred in overhead costs, which is used to help in day-to-day operations.
Anticipate Liquidity Needs with Flexible Budgeting
For a business to manage its cash flow well, it is required to budget cash flow so as to know the amount of money coming into the company and the amount going out of the business. By doing this, the business can be proactive as it can easily identify when the entity will be experiencing cash flow problems early enough before they become serious. Instead of making one big yearly budget, it’s better to use rolling forecasts, which are updated regularly based on current sales, expenses, and market changes. This makes it easier to adjust plans as things change. Additionally, a business needs to have an emergency fund where unexpected expenses are being paid through it.
Common Mistakes in Working Capital Management
- Overstocking– this mistake occurs when a business buys excess inventory than the one that is required to have. This results in higher insurance costs, storage costs, high risks of damage and obsolete. Additionally, the excess inventory in the business immobilizes capital that could be allocated to higher-value opportunities and used to meet the business’s obligations. Good inventory management is needed to ensure the correct goods and the right quantity are being procured.
- Delayed Supplier Payments-Without suppliers, a business will not operate because they provide goods for resale and raw materials for production. When suppliers are not paid on time, the relationship between businesses will be damaged. They will not offer discounts to the business, stop supplying goods to the company, and tighten the credit terms. Paying on time is recommended, and if the payment is delayed, the supplier needs to be informed.
- Poor Oversight of Account Receivables– Many businesses make this mistake by not following up on the debtors. When they don’t follow up quickly after their customers fail to pay on time, they end up not paying at all. This reduces the amount of cash available for daily operations, and the business will end up operating in losses. The business needs to come up with a clear plan for reminding its customers to pay their debts.
- Overdependence on short-term financing– One of the main disadvantages of short-term loans is the high interest rates and the short repayment period, as they need to be paid in less than one year. A business that depends on short-term loans to fund its operations can be posed with risk as it will be required to pay high financial costs over a shorter period.
Read Also: The Impact of Inflation on Individual and Business Strategies
Utilizing Technology to Enhance Working Capital Efficiency
As outlined by Imarticus (2025), Businesses can easily leverage technology to optimize their working capital. Technological tools like automation and data analysis tools are used to ensure that their cash flow is efficiently managed. Below are the tools a business uses to optimize working capital.
Electronic payment and involving systems
This is a method through which a business is able to send and receive invoices automatically and digitally. This innovation has improved the speed at which businesses are paid, as the invoices are sent to the customers promptly without errors or forgetting, as opposed to manual invoicing, where even a business may forget to send an invoice. This has improved the company’s cash flow and the period it takes before a business is paid.
- Cash Flow Management Platforms– a business can use a tool like Enterprise Resource Planning, which monitors expenses, income, payables and receivables in real-time. This helps a business evaluate its income and spending and make decisions on how to spend and invest its resources.
- Automated Credit Controls –these are Al-powered tools that a business can use to assess the creditworthiness of its customers before offering credit services to them. This helps manage the business’s account receivables, as the goods sold in credit will be provided to creditworthy clients who are likely to make payments quickly.
- Machine Learning Models for Demand Forecasting – help a business by analyzing market conditions, such as predicting the change in demand for goods and services. This enables a business to manage inventory by knowing the amount of goods it can buy for resale rather than overstocking inventories.
Conclusion
Managing working capital is an essential aspect for a business to enable it to have smooth operations and meet its short-term obligations when they fall due. Many companies fail to efficiently manage their cash flow by making common mistakes like overstocking of inventory, late payment of suppliers, depending on short-term loans and ignorance to follow up their debtors. A business can easily avoid this and ensure optimized working capital by implementing strategies like efficiently managing the business’ accounts payable and account payables, removing unnecessary operational costs, managing the inventory and making a flexible budget that adapts to the change of liquidity needs of the business.
