Working capital management strategies for small business
Developing working capital management strategies for small business is the key to success.
Working capital management definition as per Wikipedia includes this key element ‘Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.’
The key element of working capital is cash, which is a business’s life blood and every business owners primary task is to help keep it flowing and positive. Cash is what usually flows from business profits, but this is not always the case and it is important to have the strategies in place to keep this positive.
If a business is operating profitably, then it should, in theory, generate cash surpluses – so long as the receivables are being received, stock is not being over-stocked and payables are being managed properly! However, the faster a business expands, the more cash it will need for working capital and investment and this is where the term ‘Over Trading’ comes from, which is where a business expands faster than it is generating cash and in the end will run out of cash and can end in failure.
I think sometimes in small businesses the importance of working capital management is under estimated, but in reality sometimes small business owners don’t always have the time to manage this. However, setting aside time to develop working capital management strategies, will pay dividends in the long-term and help your small business grow and be more profitable.
The advantages of working capital management are significant and include:
- A cash positive business is more likely to survive in the long-term.
- In a down-turn, a business with good working capital management is better able to cope with the down-turn.
- A business with good working capital is better able to take advantage of investment opportunities that present themselves.
- A business in good shape with good working capital levels is likely to be more profitable.
Working capital management ratios for a business to be aware of include:
Current Ratio
This is your current assets divided by your current liabilities (Liabilities due within one year) – the higher this number the better health your business is in, especially if this is above 1 or higher. If the Current Ratio is below 1 there could be liquidity problems with the business. The current ratio is a financial ratio designed to tell you the level of current assets compared to current liabilities.
Quick Ratio
This is your current assets, less your stock and work in progress, divided by your current liabilities (Liabilities due within one year) – the higher this number the better health your business is in, especially if this is above 1 or higher. A company’s Quick Ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. For this reason, the ratio excludes inventories (stock and work in progress) from current assets.
However, having set out the above two ratios, there are two elements in the business cycle that absorb cash and are included within current assets, this include:
Inventory (stocks and work-in-progress) – It is vital to keep a tight control over stocks and work in progress. There is no point in having high levels of stocks (which you have to pay for in cash) sitting on your shelves. Only carry stock levels to a level whereby you can receive new orders in time to meet your orders, with a bit of extra for a comfort level. Also, you need to keep an eye on work in progress, as if this is too high also, there is a lot of cash tied up. Work in progress needs to be converted to receivables and then to cash as soon as possible after the work is completed.
Receivables (debtors owing you money) – The main sources of cash is Receivables form your customers. Make sure you have a good credit department which sets realistic credit levels for customers. Also consider what payment terms you offer, as the longer the term you offer, the more cash you will have tied up in your receivables. Then make sure you adhere to your credit terms – or should I say make sure you have a good credit control system in place to make sure your customers adhere to the credit terms they signed up to. A quite note and human nature kicks in here – most people will not pay a debt unless they are chased. So although someone agrees to pay within say 30 days, if they are not chased around the 30 day mark, they will sit there and wait for the chaser call or letter!
Cash flow can be significantly enhanced and hence your working capital, if the receivables are collected faster. Every business must know: who owes them money; how much is owed; how long has it been owing; for what it is owed. It can be enhanced also, by keeping a healthy and regular check on inventory, make sure the stock you are carrying is at the right levels and keep an eye on any increased levels of one inventory item over another. On the other hand,insufficient stocks can result in lost sales or delays for customers, which is never good for business.
Management of your payables is just as important as the management of receivables, striking good credit terms is a vital part of running any business and this represents ‘Free’ finance, as suppliers don’t charge interest on outstanding balances, whereas banks do. However, it is important to look after your creditors, as slow payment by you may create ill-feeling between you and your supplier, but it can also signal that your company is inefficient or worst still in trouble!
Make sure you carry out regular monthly analysis of your working capital – management accounts should not only include your profit and loss, but also your balance sheet, with the key management ratios of how the business is doing.
When planning the development of your business, it is critical that the impact of working capital be fully assessed. Cashflow forecasts are an essential part of this planning process and our financial planning software packages. Our Cash Forecaster Software will facilitate this task, as they provide the platform for the setting of targets for receivables, payables and inventory.