Working capital provides a measure of the operating cash flow that companies need to fund their daily operations. Owners and managers must clearly understand how working capital impacts the health and viability of their businesses. Those with an effective working capital management strategy help ensure the continued success of their companies. Two major components of any effective working capital management strategy are a rigorous, enforced accounts receivable policy and beneficial supplier and vendor terms on accounts payable.

Working Capital Description

Working capital is the cash that flows in from the conversion of short-term assets to cash less the cash that flows out to pay short-term liabilities. Working capital provides companies with the critical funding they need to operate day to day. Short-term, or current, assets include cash, accounts receivable, inventory, notes receivable and prepaids. Prepaids, which involve payments made by companies in advance for services not yet delivered, include insurance and rent. Short-term liabilities include credit lines and accounts payable.

Working Capital Management

The level of working capital a company has tells how well-positioned it is to meet its short-term cash needs. When a business has accounts receivable that quickly turn over and much more cash in its bank accounts than it has payments due to suppliers and lenders, its risk of stoppage due to lack of cash drops precipitously. Managing working capital effectively helps ensure the availability of an acceptable level of working capital at all times. Because working capital often fluctuates within a specific accounting period, many companies use credit lines to cover gaps as part of their working capital management strategy.

Accounts Receivable

Receivables and their aging -- the amount of time it takes to receive payment on an outstanding receivable -- heavily impact working capital and cash flow. If a sale occurs, but the company must eventually write off the receivable, the company receives no cash. Companies with strong credit policies, early payment incentives and customer follow-up procedures that ensure on-time payment generate more operational cash flow. Companies can also tie sales commissions to cash collection to help drive A/R conversion.

Accounts Payable

Accounts payable also plays a significant role in working capital management. Accounts payables are unpaid bills that include outstanding invoices from suppliers. The goal of an effective working capital management strategy is to closely match cash inflows with outflows. Therefore, the longer a company can extend out its payment to suppliers and vendors and the sooner it can receive payments from customers, the more working capital it will hold in cash. As part of the strategy, companies focus on building trade credit and extending terms from “due upon receipt” to 15 days or 30 days and obtaining and using vendor credit cards.