Hands drawing a chart on a piece of paper, a laptop, documents, and a plant on the desk, working capital.
2. October, 2024

Working Capital Optimization: An Assessment or a Guess?

In today’s dynamic business environment, companies must continuously adapt their capital structure to maintain liquidity while seizing growth opportunities. Effective financial management heavily relies on managing working capital, a task that is not always straightforward. This raises the question: Can optimal working capital be reliably calculated, or is it more of an estimation or guesswork?

Working Capital Can Be Challenging to Determine

Companies face the challenge of rapidly adjusting long-term financing to reflect changing business conditions. In theory, they should predict future working capital needs and include a buffer to account for potential miscalculations. However, practice reveals that a company’s lifespan may not be long enough to base these estimates solely on its historical data.

Thus, determining optimal working capital often depends on analyzing balance sheet data from numerous companies. However, studies show that even this approach may not provide a sufficient capital reserve that is both safe and economically viable.

Capital Structure and Solvency

With the increasing amount of data and advances in analytical techniques, companies can more accurately monitor their capital adequacy. The essential link between investors, who fund the company, and business operations, which generate liquid assets, is often reflected in the availability of liquid assets. If these assets are insufficient, companies may rely on short-term financing, which can lead to insolvency risks.

Conversely, excess liquid assets can reduce the return on capital, which is also suboptimal for the company. Therefore, when planning liquidity reserves, companies should consider the impact of long-term decisions as well as operational business factors.

Growth

Company growth is complex and cannot simply be predicted based on historical data. In 1931, Robert Gibrat introduced the theory that company growth is proportional to its size, leading to a log-normal distribution of company sizes. However, empirical data shows that changes in business volume are often unpredictable and influenced by various factors that frequently follow a power-law distribution.

This means that while large companies may experience minor changes, smaller companies can see significant growth surges. When forecasting working capital needs, companies must recognize that such changes are common and challenging to predict.

Managing Working Capital: A Key Task for Every Company

Effective working capital management is essential for any company, but determining its optimal level is challenging. Business risks and unpredictable growth surges require companies to plan for financial reserves, which must be carefully considered; excessive reserves can jeopardize profitability. Combining practical data analysis with simulations can help in assessing the required working capital, though complete forecasting accuracy remains elusive.

How Can Unija Help?

At Unija, we assist in improving working capital management with our advanced accounting, financial, and advisory solutions. We consolidate and analyze financial data to give you a clearer view of your business and cash flows. Through modern analytical tools, we provide valuable insights into optimal working capital levels and help you adjust your capital structure in response to a changing business environment.

We can also advise on creating flexible liquidity management strategies, encompassing both short-term and long-term planning, helping you navigate unpredictable market conditions while avoiding risks associated with either too little or too much working capital reserve.

Unija is a reliable partner, offering a blend of expertise, experience, and advanced tools to help companies better plan, enhance financial stability, and achieve long-term growth success.

If you need consulting support or comprehensive capital structure monitoring assistance, feel free to contact our experts HERE.