When the business decides to reduce Working Capital, then additional money can be released to be used by the business as a source of finance. So, businesses may be able to use some of their Working Capital to raise additional funds for other long-term projects.
In order to reduce Working Capital, the business should decrease Current Assets or increase Current Liabilities. The former one is safer. The later one can cause liquidity problems.
Let’s see how to reduce working capital.
Decrease Current Assets to reduce Working Capital
- Lower Cash balances. Any cash a business has can be used to finance capital expenditure instead of paying for revenue expenditure. However, businesses must make sure that they have enough cash to finance their day-to-day expenses, short-term debts and any unexpected expenditure. If too much cash is used to finance capital spending, they risk not being able to pay day-to-day expenses. This could seriously threaten the survival of the business.
- Reduce Inventory (Stocks). The business may decide to reduce the quantity of raw materials, components or finished goods it holds. For example, if a business has inventories valued at USD$50,000 and it is able to reduce this to USD$25,000, then this will mean that USD$25,000 less cash is tied up in inventories. This USD$25,000 in cash is now available for other, more profitable, uses.
- Reduce Debtors (Trade Receivables). Most businesses sell goods to customers on credit. This means that customers receive the goods today, but pay for them at an agreed date in the future, e.g. 30, 60 or even 90 days after delivery. A business can reduce the length of time it has to wait for payment by making sure that customers pay on time or by offering discounts on early payment. By reducing the total amount of debtors, the business’s cash balances increase and this provides a possible source of internal funds for capital expenditure.
Increase Current Liabilities to Reduce Working Capital
Additionally, the business may increase Current Liabilities by maxing up bank overdraft or taking another short-term bank loan.
- Increase Overdraft. Max up bank overdraft and always pay it back at the latest possible time.
- Delay Creditors (Trade Payables). Always purchase supplies from suppliers using trade credit. The longer the terms of the trade credit are, the better for your business.
- Delay TAX. Delay TAX payments the government as much as possible.
- Increase short-term bank loan. Take another short-term bank loan. Paid to the bank on any borrowings shorter than 12 months.
- Delay Dividends. Change the way how your company pays dividends to shareholders from monthly, quarterly or biannually into annually, preferably at the end of the year.
However, there are risks in cutting down on Working Capital in this way. Increasing the firm’s Current Liabilities might be risky. It may lead to liquidity problems – not being able to pay short-term debts on time, hence stoppage times, or even getting out of business.
