As an attorney and a leader, wouldn’t it be useful to have a tool that allows you to assess the health of your firm on a regular basis? Fortunately, accomplishing this is not as opaque as it may seem. The term “working capital” gets thrown around a lot in the business world, along with similar terms such as “working capital management” and “net working capital.” These words can be confusing to someone who’s not well versed in business school nomenclature. This post is first in a series meant to uncover the basics of working capital management for attorneys so that our readers have a better understanding of how working capital impacts their firm’s day-to-day operations and future growth potential.
What is working capital management?
Investopedia defines working capital, also known as net working capital (NWC), as the difference between a company’s current assets, such as cash and accounts receivable (customers’ unpaid bills), and its current liabilities, such as accounts payable or short-term debt obligations. Furthermore, working capital is a measure of a company’s liquidity, operational efficiency, and its short-term financial health. Positive working capital indicates that a company can fund its current operations and invest in future activities and growth.
Here is a simple illustration of working capital:
Why should law firms care about working capital management?
Put simply, cash is king. Or rather, positive working capital is king. Here is a short list of benefits stemming from strong working capital management:
- Being able to cover short-term obligations comfortably
- Having liquidity to continue investing in the business (hiring, upgrading systems, sales and marketing, expanding to new markets, and so on)
- Ensuring clients aren’t taking advantage of lengthy payment terms or delaying the cash that should be coming into your bank account
- Managing the timing of payments to outside vendors in such a way that optimizes cash flow
- Measuring the health of the business in terms of revenue, cash collection, and expense management
If these benefits are appealing to you, we are glad you found this post and would highly recommend reading on.
What are some key ratios for working capital management?
In finance and accounting circles, metrics and ratios are a great tool for spot-checking how well a firm is managing a certain aspect of their business. Rest assured, you don’t need to know everything there is to know about accounting, but you should understand that these numbers are critical to the financial health of your firm. For example, any law firm leader will want to understand the health of their revenue and gross profit at any given time. And there are a variety of metrics that can provide insight into this. The same goes for working capital management. Here are some important ratios to know about that will help attorneys measure how well they are managing working capital:
- Working Capital Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
- Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
What should I be thinking about next?
This is the first in a series of five posts about working capital management. In subsequent articles, we will go into more detail on:
- Cash management and bank accounts
- Accounts receivable and client collections
- Accounts payable and vendors
- Credit cards and other short-term debt
If you’re willing to put in the time to learn these concepts, or have someone you trust help get you there, each of these topic areas will unpack the essence of working capital for law firm leaders who are interested in mastering one of the key tenets of financial management in a business.