How early payments increase your working capital
Every organization wants to have a reliable flow of cash to help finance its bills and grow. But many businesses struggle with securing payment from buyers, leading to a gap in cash flow that harms their working capital. Using early payment solutions, some companies have successfully created a positive working capital that leads to better funding, more investor opportunities, and an organization primed and ready for growth. To help you revolutionize how your organization tackles early payments, we’ve broken down the components behind using early payments to increase working capital.
What are early payments?
Just as they imply, early payments are finances that you secure from your accounts receivables earlier than the listed maturity date. Often, organizations rely on an early payment discount program to offer their customers an incentive to complete payment for goods and services more quickly. When early payment programs are set in place, the customer enjoys paying a discounted rate from the full amount due to paying ahead of schedule. The supplier enjoys quicker access to their cash, helping to enhance their organization’s liquidity.
In other words, a buyer will pay less than the full amount due while the supplier receives payment earlier than they would through a standard payment cycle.
How do early payments affect you?
When you incentivize early payments, you help reduce the likelihood of nonpayment or late payments from your buyers. Additionally, it accelerates your business’s cash flow. This means you have greater access to cash to curb expenses and manage debts.
Additionally, having greater access to cash creates a liquid business function. This directly impacts your enterprises’ working capital. As your working capital rises, you’ll find your business process to become stronger, more streamlined, and more secure.
Defining working capital
Working capital, also commonly referred to as net working capital, is a metric used to measure the financial health of a business in the short term. The calculated working capital indicates an organization’s ability to pay off its outstanding bills and debts or, in other words, showcases a company’s liquidity.
It isn’t difficult to find your working capital, seeing as all the data you need is included in your balance sheet. To calculate the working capital, you simply need to subtract your current assets from your liabilities. This value can result in positive or negative working capital.
Positive working capital — A positive working capital means your business currently has more cash value than your short-term debts. If your working capital is positive, it means you have enough cash value (or liquidity) to pay off all the existing bills and expenses you have, with some cash leftover. Investors and lenders are usually more willing to fund organizations with positive working capital when it comes to fundraising.
Negative working capital — As you’d expect, negative working capital is the opposite of positive working capital. If your business has a negative working capital, it means you do not have enough cash value or liquidity to cover all your liabilities and existing bills. Enterprises should strive to avoid having negative working capital, as it can be a red flag that deters investors and lenders. Businesses should attempt to increase their cash flow and move back towards positive working capital.
Calculating working capital
Determining your working capital doesn’t require an advanced math degree or difficult formula. The process is rather simple. To figure out your working capital you can use the following calculation:
Current Assets — Current Liabilities = WC
To get the information you need, you simply need to look at your balance sheet. Don’t have a balance sheet handy? Not a problem! You can manually calculate your working capital by adding up all your current assets and liabilities. Below, we’ve identified some of the most commonly listed assets and liabilities companies have:
Current assets involve the cash you hold as well as any cash you have guaranteed coming in, typically including:
- Accounts receivables
- Cash equivalents held in bank accounts
- The value of the inventory you hold
- The value of marketable securities like common stock
Current liabilities are the short-term debts that you have to pay off within the year. Some examples include:
- Accounts payables
- Credit card balances
- Wages payable
- Outstanding loans
What are the components of working capital?
When calculating the immediate profitability of your company, there are four distinct factors that you should consider:
- Cash and cash equivalents — liquidity is a crucial pillar of working capital. And nothing is more liquid than cash. Cash is ideal for curbing operating expenses and covering debt. Cash equivalents, or assets that can be converted into cash fairly easily, operate like cash. These assets will face some slight loss in value if you need to convert them into cash quickly. Some examples of cash equivalents include money market accounts, U.S. Department of Treasury bills, stocks, bonds, and exchange-traded funds. Behind cash, your cash equivalents are the most liquid of listed assets.
- Accounts receivable — the money others owe your organization makes up your accounts receivable. This includes outstanding invoices that you expect to collect payment on in the near future, outstanding credit you might extend to other companies for business reasons, any interest you might have charged others, and checks that you have yet to cash. Until you receive payment, these items fall into the accounts receivable category. Once you’ve collected payment, they fall into the cash category.
- Inventory — if your company deals with tangible objects and inventory, you need to track these items before they are sold or used in service for customers. Since you have the intention to sell these items to customers, they can be counted as an asset for your company. Your inventory includes items on display in a store, items stored in warehouses, and items being transported from your suppliers.
- Accounts payable — on the liabilities side, the accounts payable category is your pillar. You need to add up the total value of all your outstanding bills and debts that you expect to pay within the next 12 months. Any debts that are due later than 12 months are not included in your working capital calculation. Liabilities you should include are supplier or vendor invoices you need to pay, expenses associated with operations, outstanding debts, and any upcoming tax payments.
How do early payments increase working capital?
In many cases, organizations offer early payment solutions to suppliers in return for a discounted rate. This is a solid strategy to support raising your working capital, as it incentivizes suppliers to pay off their receivables at a faster rate. This helps increase your cash flow, lessening the pressures suppliers can face when dealing with longer payment terms and late payments.
To learn more, reach out to our team of experts. We’re standing by, ready to help you make shift happen in your organization.