How Net Working Capital Can Make or Break Your Business

Net working capital (NWC) is a crucial metric for any company in the $5M to $100M revenue range. It reflects a business’ ability to meet short-term demands and conduct business efficiently. Mastering NWC can bolster cash flow, financial flexibility, and access to capital. This article explores what net working capital is, why it matters, and how micro and lower middle market companies can improve it.

What Is Net Working Capital?

Net Working Capital is the difference between a company’s current assets and current liabilities. It provides a snapshot of short-term financial health and operational efficiency.

Formula: Net Working Capital = Current Assets – Current Liabilities

A positive NWC means the company has more short-term assets than liabilities, demonstrating financial strength. A negative NWC may point to liquidity issues, though this isn’t always negative depending on the business model.

Why it Matters for Growing Companies

Companies generating between $5M and $100M in annual sales often operate in competitive environments with tight margins. Optimizing NWC isn’t just good financial hygiene – it enables growth.

Managing NWC effectively allows businesses to:

• Fund day-to-day operations without external financing
• Take advantage of market opportunities with available cash
• Strengthen their position when negotiating credit or acquisition deals

Cash flow challenges are common for companies in this range. Delayed receivables or excess inventory can quickly drain liquidity. Maintaining NWC is a proactive step toward long-term health.

Components of NWC

Understanding each component of NWC is key to managing it effectively. Here’s a breakdown:

Accounts Receivable (AR): Money owed by customers. Slow collections increase AR and tie up cash.

Inventory: Raw materials, work-in-progress, and finished goods. Too much inventory means capital is tied up.

Accounts Payable (AP): Amounts owed to suppliers. Longer payment terms can improve liquidity, but overly delayed payments can damage supplier relationships.

Accrued Expenses and Short-Term Debt: These liabilities represent cash that must be paid soon. If not carefully tracked, they can create surprises in cash flow planning.

Optimizing NWC

There is no one-size-fits-all solution to managing net working capital. However, companies in the lower middle market can deploy several proven strategies to achieve a healthy balance.

1. Improve Accounts Receivable Turnover

Accelerating collections is one of the fastest ways to free up cash. Consider tightening credit policies, offering early payment incentives, creating automated reminders, and following-up on overdue invoices.

Clear communication with customers reduces disputes and delays. Companies with better AR systems often see major cash flow improvements within a single quarter.

2. Reduce Inventory Without Sacrificing Sales

Inventory can become a silent killer of working capital. Holding too much leads to aging or excess inventory, while holding too little risks running out of stock.

Use demand forecasting tools and analytics to time orders better and adopt just-in-time practices where feasible. Evaluate slow-moving SKUs regularly and discount or bundle them to clear space and free up cash.

3. Extend Payables Strategically

Negotiate longer terms with suppliers, especially those you have good relationships with. Taking full advantage of payment terms (without crossing into late payment territory) allows businesses to hold onto cash longer.

However, be cautious not to strain vendor relationships. A reputation for timely payment can sometimes yield better terms in the long run.

4. Monitor Short-Term Debt Carefully

Short-term debt is a double-edged sword. While it provides flexibility, relying on it too much can put pressure on working capital. Use revolving credit lines and align debt repayment schedules with predictable inflows.

Track covenants associated with debt agreements. Violating covenants can lead to unexpected calls on capital.

5. Leverage Technology and Reporting Tools

Invest in enterprise resource planning (ERP) or financial reporting tools that offer real-time visibility into receivables, payables, and inventory levels. Automated reporting allows you to detect imbalances and act swiftly.

Dashboards that track accounts receivable aging, accounts payable aging, and inventory aging are especially useful for tracking performance.

The Role of Net Working Capital in Business Valuation

NWC is often a focal point during mergers, acquisitions, and capital raises. Buyers and investors use normalized NWC levels to assess ongoing capital needs. Unexpected swings in working capital can derail deals or reduce valuation.

Companies with strong working capital practices attract better terms from institutional investors. They command higher valuations due to predictable cash flow, and face fewer surprises during due diligence. In deals involving earnouts or performance-based incentives, stable NWC can protect sellers from post-transaction disputes.

Customizing NWC Targets by Industry

Not all industries operate on the same working capital cycle. For example, wholesalers may hold more inventory but collect faster, while SaaS companies may have minimal inventory and high deferred revenue. Manufacturers typically manage complex supply chains and vendor terms.

Micro and lower middle market firms should benchmark their net working capital against peers in the same sector. Industry-specific nuances can shape what “healthy” net working capital looks like.

Common Pitfalls

Even financially sound companies can mismanage NWC. Here are some pitfalls to avoid:

• Chasing top-line growth without considering liquidity: Fast-growing companies often outpace their cash collection capacity.
• Ignoring seasonal cycles: Failing to anticipate seasonal demand can lead to excess inventory or cash shortages.
• Over-leveraging accounts payable: Extending terms beyond 90 days can damage vendor trust.
• Poor forecasting: A lack of accurate cash flow forecasting can leave teams unprepared for shortfalls.

Building a Culture Around NWC Discipline

Finance teams alone can’t enhance working capital. Educating department heads and other key employees on how their actions affect cash conversion cycles is important.

For example, sales teams should understand how extended payment terms impact AR. Procurement should avoid bulk orders that tie up unnecessary amounts of cash, while operations should streamline inventory turnover. Regular reviews of NWC can find inefficiencies and create accountability.

How to Begin Improving Net Working Capital Today

Improving working capital starts with measurement. Create a 13-week cash flow model and begin tracking the core metrics: Accounts receivable aging, accounts payable aging, and inventory aging.

From there, figure out what’s causing the biggest problems. Set realistic goals for improvement and delegate within your team. Reviews of progress, along with incentives for goals, can drive progress.

Conclusion

For companies in the $5M to $100M revenue range, Net Working Capital isn’t just a financial ratio – it’s a measure of maturity within your business. Managing it effectively can reduce the need for outside financing, improve valuation, and position your company for long-term success.

By paying attention to AR, inventory, AP, and debt, and fostering a culture that uses company funds efficiently, you can add value to your company and strengthen its balance sheet.

Understanding and mastering Net Working Capital today will drive smarter decisions in the future.