Working Capital Management is a vital business instrument that assists businesses effectively utilize current assets, thereby assisting businesses to keep adequate cash circulating to fulfill short term monetary obligations and future goals. Properly managing working capital enables organizations to free up financial resources which would otherwise be caught in the tight balance sheets of the enterprise. This also allows enterprises to plan for future requirements efficiently and with less risk. However, inadequate management of working capital results in numerous problems for small businesses due to the fact that they are unable to deal with unexpected opportunities or circumstances.
One of the most common problems faced by small businesses is Accounts Receivable. Accounts Receivable, when viewed in isolation, appears to be simply an expense which the enterprise is able to handle on its own. However, a closer examination of accounts receivable reveals a number of details which render it an essential element of working capital management. For example, Accounts Receivable may reflect invoices which have been cleared by credit card merchants but which have yet to be credited to the merchant’s accounts.
In other words, these invoices are technically still being processed by the merchant’s credit card processor, even though the final amount has been paid. As a result, these outstanding balances become part of the enterprise’s Accounts Receivable, which may now be converted into cash to meet immediate short-term cash needs. Similarly, small businesses may experience difficulty in accurately estimating their sales and expenses over the course of the day-to-day operating expenses. Accurate, real-time sales and expense accounts receivable data is critical to setting and maintaining a successful working capital management scheme.
In addition to the difficulties faced by small businesses in reliably estimating their day-to-day operating expenses, the inability to process invoices accurately will also cause problems in working capital management. Invoices that are improperly charged, for example, will significantly affect a company’s cash flow. Conversely, accounts receivable that are properly credited will facilitate the smooth processing of cash payments to vendors and will help a business avoid the cost of credit card interest. Properly credited invoices will also increase a company’s credit ratings and will contribute to its ability to raise capital through traditional loans and commercial mortgage. As such, proper management of receivables will play a significant role in sustaining a healthy cash flow, and will help to ensure that a company remains profitable and able to attract investment and expansion capital.
In order to better understand how invoicing works in relation to working capital management, it is necessary to understand how inventory turns over and why it occurs. Essentially, inventory refers to the goods that a business sells to customers over the course of a month or year. While a typical business may process tens of thousands of orders during a typical month, it would be difficult for that same business to manage its inventory, since most sales do not result in immediate payment. In addition, inventory is one of the primary ways that businesses keep tabs on their expenses and can often provide a quick look at the current state of their cash flows. By closely tracking their inventories, businesses can determine which items they need to replace, which vendors to contract with, and which products they should hold on to until they can fulfill their orders.
Short term financing options are often used to cover short term cash needs. A company’s accounts receivable and inventory will likely reflect the amount of cash they have on hand at the current time. However, if a company does not process all of their accounts receivable in a month, they may find themselves in a situation where they are holding on to unsold inventory. In this case, they will need to access their current liabilities in order to generate the funds they need to settle their accounts receivables, and to pay their inventory bills.