Working capital and the working capital ratio are some of the lesser known metrics for e-commerce businesses. You’ve likely heard of e-commerce KPIs like inventory turnover and average customer order. But what is working capital? And how can you make sure you can optimize it for success?
In this article, we’ll give you a comprehensive understanding of why it matters and how it works. Then, we’ll recommend strategies for improving your working capital ratio including data analytics, inventory management and long-term loans.
Working capital in e-commerce: What it is and why it matters
Working capital is your current assets minus your current liabilities. It is what you have left over after you’ve subtracted everything you owe from everything you own. The working capital ratio is your current assets divided by your current liabilities. It represents your ability to pay off debts with what you own in the short-term.
Working capital goes hand in hand with your cash flow. Cash flow gives you an indication of the amount of cash you’re generating whereas working capital will specifically consider your assets and liabilities. For instance, looking at cash flow alone won’t give you an understanding of assets (such as accounts receivables) that you can quickly convert into cash in a pinch.
What is a healthy working capital ratio for e-commerce?
In e-commerce, your working capital represents your ability to pay for day-to-day expenses, unexpected costs and potential opportunities. For example, if customer demand is rising, you’ll want to have enough assets to cover inventory costs. However, having too many assets could indicate that you’re not reinvesting assets wisely in order to increase revenue.
As a general rule of thumb, a healthy working capital ratio in e-commerce is about 1.5:1 to 2:1, i.e. you have 1.5 to 2 times more current assets than current liabilities. However, a ratio as low as 1.2:1 could be considered healthy, such as when your revenue is extremely high.
Risks of poor working capital management for e-commerce
If an e-commerce business’s working capital ratio is too low, it may struggle to meet short-term financial obligations such as paying suppliers and employees. Working capital only considers current assets, those you can convert to cash within a year, since having lots of high-value, non-current (fixed) assets such as equipment won’t be helpful in the short-term. This can result in cash flow problems and ultimately lead to missed growth opportunities, bankruptcy, and other financial difficulties.
Conversely, if the working capital ratio is too high, it may indicate that the e-commerce business is not using its available capital effectively. Excess working capital that is not invested in growth opportunities can lead to reduced profitability. This could be not keeping enough stock-on-hand, not investing in marketing or not hiring more employees.
Use data analytics tools to track performance
Before you can start improving your working capital, you need to get your e-commerce business set up with the right data tools. The center of all financial data should be a cloud-based accounting software such as Xero or QuickBooks. You can then automatically sync transactions from your e-commerce platform with an accounting integration, e.g. WooCommerce + QuickBooks Online.
From there, you then connect an inventory management system (more on this in the next section) to your accounting software. This will allow you to manage inventory levels, make purchase orders and manage suppliers. Without accurate transaction and inventory data, your working capital ratio would be skewed.
Now that you have all your data flowing to your accounting system, you can now integrate it with a data analytics tool such as Syft Analytics or Spotlight Reporting. These tools will give you real-time insights into your working capital and allow you to generate working capital reports.
Why you need to improve inventory management
As a current asset, inventory directly impacts your working capital ratio. However, inventory doesn’t necessarily hold the same value as other current assets like cash, cash equivalents or accounts receivable. First of all, you don’t have full control over how quick the inventory can be sold (how quickly it converts into cash). Secondly, if you have too much inventory, it can depreciate in value over time.
Hence, inventory management is key to your working capital management. Inventory management involves keeping track of your stock levels, ensuring you don’t have too little or too much inventory, and ordering more stock at the right time. Inventory management systems like Unleashed Software or CIN7 can help you streamline these processes.
Why you should use long-term loans
There’s an ongoing mentality that it’s safer to pay for all assets with cash. Unfortunately, even though it does help with peace of mind, paying for non-current (fixed) assets with cash can negatively impact your working capital. For example, if you spend your cash paying for equipment and property, you won’t be able to convert these assets back into cash quickly if you needed to.
Instead, you can use long-term (longer than 12 months) loans to your advantage. Even though you have to pay interest, being able to have more cash will typically improve your ability to grow your business. This could involve securing discounts from suppliers for being able to pay them quickly, investing in marketing or securing more stock on key items. Eventually, you make back the cost of the loan.
Key takeaways on working capital in e-commerce
Working capital and the working capital ratio are important but less widely understood e-commerce metrics. To avoid the risks that come with poor working capital management, e-commerce businesses can introduce strategies that include data analytics, inventory management, and long-term loans.