Working Capital Management
When it comes to cash flow, analyzing your working capital is one of the most important areas to focus on, as poor management can lead to you running out of cash and having difficulties paying suppliers.
You may be wondering, “What is working capital?” or “How does it affect my business?
This article will walk you through how to understand the concept of working capital and its importance to your business.
What is working capital?
Working capital is the money used to cover short term expenses within a business, including inventory, short term debt and day to day operating expenses.
Why is working capital management is important?
Working Capital is a crucial measurement and should be monitored regularly with a minimum of at least once per month. The reason for an ongoing review is the amount required is likely to change regularly especially if you have stock purchases or seasonality’s within a business model, therefore what you needed last month, might change this month if you have additional outgoings to meet with less cash income being generated.
Understanding Working Capital Management
The main purpose of working capital management is to maintain sufficient cash flow to meet short-term operating costs and debt obligations. It is essentially the money a company has available after they receive cash from customers and pay their suppliers (this is known as current assets minus current liabilities on the balance sheet)
Key components of the working capital cycle would include
- Trade debtors
- Trade creditors
Other creditors such as taxes due for VAT etc.
You can monitor your working capital effectively by implementing a cash flow forecast and using working capital rations such as debtor, creditor and stock days to monitor how efficiently you collect and payout cash over a period of time. You should constantly try to improve your cash cycle by finding opportunities for customers to pay you as early as possible and delaying your payments to suppliers, which is done by leveraging favourable payment terms.
Factors That Affect Working Capital Needs
Each business needs varying amounts of working capital to run effectively. There will be elements of working capital easier to manage than others, for example, internal factors such as the company structure, operations and strategy are easier for management to control, whereas external factors such as interest rates, borrowing capacity and market conditions are more difficult to predict.
This is why ongoing management with a longer-term outlook is crucial as you can spot potential risks earlier and have time to implement strategies, rather than getting to the ‘week’ and realizing you will run out of cash which causes extra management time, stress and also relationship issues if you have to delay payments.
Effective working capital management
In the simplest form, you will continue to improve working capital as you get cash in quicker from customers and have longer to pay cash out to suppliers.
Managing this process does take time and should have its own strategy as to be offered better payment terms and funding you need to have a good financial plan, work with suppliers that trust you, and have a good credit rating
So how can you start to implement a good working capital cycle?
Firstly you need to understand your current cycle. The best way to do this is to analyze your financial ratios. Some key working capital and liquidity ratios are:-
Debtor days – no of days it takes for customers to pay you
Creditor days – no of days you averagely takes to pay the supplier
Stock days – No of days it takes you to sell through stock
Current ratio: How easily you can pay off your liabilities
Acid ratio: This is the current ratio (less stock) as stock generally takes longer to convert into cash than other current assets
Using a ratio on its own will not really be effective, you should compare month to month but also against industry averages. For example, the high-value retail stock is likely to take longer to sell through than groceries as you would expect the edible stock to sell through quickly or it will become obsolete, therefore ensuring you review against your own targets but also against your industry will help you implement the right level of working capital.
Once you know your cycle then it is time to start looking at ways to improve
4 Tips for Effective Working Capital Management
There are four key things we would recommend for managing working capital:
Improve inventory sell-through rates
Inventory can be one of the hardest things to manage in a business and have the biggest risk. Slow-moving inventory means you have extra costs for storage, risk of decline in market values or changes in demand where stock becomes obsolete. It is still worth selling through stock even if the value has dropped so you use cash tied up, however, the best strategy is to have a good operational cycle that purchases and buys to minimize the risk of having to write off stock or sell at low margins.
This means you need a good inventory strategy…
But who does this? Who manages it? Who negotiates costs with suppliers? What reporting do you get to track? How often do you track it?
Having good stock management requires accurate and timely reporting so you can make quick decisions and implement new strategies.
Request payment terms with suppliers
As a business grows the volume of expenses can increase rapidly and ultimately the number of suppliers. It is often not a priority for business owners to think about contracts with suppliers and many growing SME’s will pay invoices immediately (or when chased) because it is easier to manage as they have no way of tracking what is due. As your business scales this will eventually lead to your creditor days reducing as you pay out too quickly, so how can you change this?
When you set up a new deal with a supplier one of the key questions should be ‘what payment terms can you offer trying to get +30 days or even longer up to 90 days will give you a much better cycle, as you have longer to sell customers and generate cash in to pay the costs.
Although remember payment terms will mean you need good relationships with your suppliers, so once you agree to the terms, it is important to have a process enabling you to keep track, sign off spend and pay to terms, otherwise it is easy for a supplier to change and demand payment upfront!
Receive adequate financing
Financing is a great way to get bulk funding into your business. Lenders can be strict when offering finance and depending on the ‘value’ of cash you need will generally determine the level of information they request.
Most lenders will want a business and financial plan, so they can see how you expect to utilize the cash and ‘how’ you are going to grow the business. It is best to have a detailed plan as the more information you can provide the more likely they will ‘trust’ in what you are presenting.
But remember you don’t always need large funding, if it is a short term gap interest-free credit cards or overdrafts can be used to fund, this is quite a common way of businesses managing short term cash flow issues.
Improve your receivables
How you collect cash from your customers is an important strategy to consider. Continuous unpaid debt can be costly and have time consequences for owners who have to keep chasing payments. Automating your collections as much as possible will reduce the risk of nonpayment and ultimately the easier a customer can pay, the more likely you will get cash quickier.
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