Imagine earning millions but having no money in hand to buy groceries or go to the movies. Sounds strange, doesn’t it? What’s the point of those earnings if they can’t be put to use to fulfill your daily requirements? That is exactly what happens to a business when it runs out of working capital. Working capital is cash in hand that keeps your small business’s daily operations running smoothly. If you were to put a formula to it, it would be:
Working Capital (WC) = Current Assets (cash, accounts receivable, inventory, and other liquid assets) – Current Liabilities (accounts payable, short-term loans, accrued expenses)
Straightforward and simple as this may look, maintaining a positive WC is no child’s play. WC is the heart of your small business, and you have to ensure it keeps beating.
Why Is Working Capital So Important?
Super successful sales and high revenue inflows do not guarantee operational ease. This is because if your business has short-term debt, pending bills, or inventory costs, most of your cash will go into managing these operating costs. Problems in operations can snowball into bigger problems, affecting your business’s profitability, credibility, and growth prospects.
A positive WC, where current liabilities are significantly less than current assets, acts as an insulator during economic uncertainty. When your business has a positive WC, you can comfortably pay off any short-term obligations without affecting your overall business and financial health. Also, working capital gives you the flexibility to adapt to sudden changes in demand or market opportunities. For instance, you can fulfill a sudden spike in demand for a product by buying more inventory or increasing production, only when you have sufficient WC to confidently back your plans.
How Much Working Capital Can Be Considered ‘Sufficient’?
There is no “golden number” when it comes to working capital. Working capital requirements can vary by business; they depend on the type of business you run and how long it takes to convert production into inventory, sales, and cash. For instance, a manufacturing business has a long production cycle and may take more time to generate working capital. But a service-based business with no production or inventory may have a shorter conversion cycle. The trick lies in streamlining this cycle to ensure your cash flow, operations, and working capital coordinate seamlessly.
That said, here are certain tips to maintain sufficient working capital and increase it, regardless of the type of business you have.
Ensuring Payments from Customers
Pending accounts receivable are a common stress point for many small businesses. However, collecting payments for products sold or services provided is your right, and there is nothing wrong with requesting prompt payment from your customers. In fact, this is the most direct way to keep your WC flowing. Having a transparent, clear billing policy, communicating it to your customers well in advance, automating invoicing processes, and sending gentle reminders if needed can ensure timely payments from customers and thus help you maintain sufficient WC. You can also offer customers discounts to speed up payments, if necessary.
Clear Credit Policy
If offering credit to your customers is part of your business strategy, checking customers’ credit history should be a part of the invoice process. Customers with a good credit record pay on time, easing the burden on your working capital. Clearly outline your credit policy, deposit requirements, payment deadline, and other details right at the beginning. Set a limit to how much credit you are willing to give, depending on your financial health, cash flow, and debt status. Insuring against customer non-payment of dues can help you manage cash flow in the event of a default.
Optimizing Inventory
The cost of holding inventory for a prolonged time often eats into your WC, leaving you with little for other operations. Instead of piling up inventory, you can adopt the Just-In-Time (JIT) Inventory strategy, in which goods are ordered and stored closer to the production schedule, thereby reducing holding costs. Calculating Economic Order Quantity (EOQ) accurately can help order the optimal quantity and minimize holding costs. The company can place orders at intervals to balance ordering costs and carrying costs.
Short-Term Financing Options
Using various short-term financing options, such as short-term bank loans, trade credit, pre-approved lines of credit, and interest-free credit cards, can give your business flexibility in terms of interest rates and repayment terms. If planned carefully, such flexibility goes a long way toward helping you smooth out cash flow hurdles and access more working capital.
Forecasting Demand
Forecasting demand using historical data and real-time expense tracking can support effective business planning, strategy, and inventory management.
Cost Optimization
Cutting costs and overheads is a great strategy to address financial difficulties. The real skill lies in doing so without compromising on the quality of the product or service. You could consider renting a smaller office space, adopting a hybrid work model, using energy-saving appliances to reduce utility bills, and negotiating better terms with suppliers and vendors. It’s the small changes that often make the biggest impact on your WC.
Avoiding Using Up Cash for Debt Repayment
One of the most serious mistakes a business could make is using up its working capital to repay short-term debts or buy fixed assets. Having used up all the cash, the business then has to take an urgent short-term loan to keep operations running, and the loan terms may not be favourable. This quickly becomes a vicious cycle of debt, eroding your credibility and reputation with financial institutions, potential investors, and even suppliers. Consider buying fixed assets with long-term loans, as they have lower monthly installments and don’t hamper short-term cash flow, which can be used to make an early payment to the supplier and secure a discount, or to invest in opportunities with immediate cash conversion.
Regularly Monitoring Working Capital
Regular reviews of financial statements and Key Performance Indicators (KPIs), such as Cash Conversion Cycle, Days Sales Outstanding, and Inventory Turnover, can help manage WC more effectively and efficiently. By regularly calculating and tracking your WC, you can also gain insights into how your business can manage challenges or hurdles without losing out on upcoming growth opportunities.
Contact Ford Keast LLP in London to Help You Manage Working Capital
Any shortage of working capital can cause hiccups in the business, leading to even bigger problems. At Ford Keast LLP, our accountants and fractional chief financial officer (CFO) can help you track stuck cash, set credit terms, smooth the invoicing process, and forecast accurately. To learn more about how Ford Keast LLP in London can provide you with the best accounting and CFO expertise, contact us online or call us at 519-679-9330.
