Working Capital – Get the balance right.
There’s no denying that running a business is an exhausting and complex
task. There’s so much to keep up with, including peaks and falls in the
market, shifting consumer behaviors, and new developments in the
industry. At any one point there’s so much to keep up with that it’s not
uncommon for things to start to slip. One thing that you never, ever want to
slip, however, is your cash flow and your capital management. It is even
more important to manage your cash flow and your capital management
now as more companies are extending their Days Payable Outstanding.
Both can do serious (and potentially irreparable) harm to your business
that can be difficult to recover from, so let’s take a look at how working
capital management can protect your business and help you thrive all at
once.
What Is Working Capital Management?
Working capital management is essentially the efforts and strategies that ensure
that companies are leveraging both their assets and liabilities in order to keep
things running smoothly. This often involves careful management across multiple
departments within a company, and may include revenue collection, inventory
management, debt management, and accounts payable.
It is, simply put, the difference between a business’s current assets and its current
debt and financial liabilities. In this case, your assets are anything that can easily
be converted into liquid cash within a 12-month period, which often includes
accounts receivable, cash, and inventory.
Efficient working capital management focuses heavily on ensuring that the
business is able to maintain the liquidity needed to keep business running while
hopefully leveraging assets as investments.
This means having enough cash flow to be able to pay all short-term expenses
and debts that could otherwise jeopardise the business or its operational status,
while trying to have funds set aside to potentially invest in the advancement of
the business itself.
Why Does Working Capital Management Matter?
Cash flow issues are a major concern for businesses of all sizes, and can be a
particularly detrimental problem to run into. One study even found that 82% of
small businesses who had to close up shop had failed because of cash flow
problems.
No one wants to run out of money, even if that just means that your funds are tied
up in other assets.
A mechanic who uses up all of their funds getting a new car lift, for example, will
suddenly have no funds left over to order in new parts, pay for marketing
campaigns, maintain yearly licensing fees, or even pay their employees. They
haven’t lost the money they put into the car lift, but it’s tied up, they can’t use it,
and now they have nowhere to go. This is an overly simplified example, but it’s a
common problem for businesses of all sizes to run into.
Working capital management can help you avoid cash flow problems that could
pose a major financial risk to your business, but it’s also crucial to help you grow.
When executed well, it can help you achieve a higher rate of return on your
capital, increasing profitability, value appreciation, and liquidity all at once.
The 3 Ratios You Need to Know for Working Capital Management
When it comes to working capital management, there are three ratios you need to
stay on top of things.
The first is the working capital ratio, which is calculated by your current assets
divided by your current liabilities. This can be an indicator of financial health and
liquidity, particularly in terms of whether or not you can meet all your short-term
debt and financial obligations. While the ideal working capital ratio varies heavily
by industry, keeping your ratio above 1.0 is a good sign, and closer to 2.0 suggest
you are in a healthy position.
The second is your inventory turnover ratio. This is calculated by dividing the
cost of goods sold in a set period of time by the average inventory cost of that
period. Average inventory is typically used because most companies’ inventory
fluctuates wildly throughout the year, so this will give you a better big-picture
view.
Your inventory turnover ratio can help you ensure that you’re not having too
much of your capital stuck in inventory that isn’t moving, which could potentially
cause cash flow issues. For this, you want your ratio to be pretty middle of the
ground; low ratios may indicate that you’re inventory is using too much capital,
while higher ratios may mean that you don’t have enough inventory to keep your
customers happy.
The third is your collection ratio, which is calculated as “the product of the
number of days in an accounting period” multiplied by “the average amount of
outstanding accounts receivables” which is then divided by “the total amount of
net credit sales during the accounting period.”
This ratio measures how efficiently your business is measuring your accounts
receivables, and it looks at how many days it takes on average to receive payment
after invoicing or transactions. You want this ratio to be as low as possible
because a low collection ratio means much better cash flow for your business.
Companies whose customers typically pay promptly and on time will do well
here.
Leveraging Your Working Capital Correctly: Striking the Balance
There’s a lot to consider when you’re looking at working capital management,
and the right balance will be different for every business. It’s not uncommon for
newer businesses to need to invest more, for example, and to have lower assets
overall while they get started. Look at your industry, your direct competition, and
consider what you feel comfortable with.
When it comes down to it, you’ll find that there are three commonly-used
policies of working capital management approaches. These are:
• A relaxed, conservative approach, where a high level of assets are
maintained in order to balance out the existing liabilities. Liquidity is high,
but unfortunately, this can impact your profitability negatively. It’s safe but
may not yield as a big of a payoff.
• A restricted, aggressive approach, which maintains a lower level of
current assets than the conservative approach. Liquidity is typically very
low here, which is risky, but profitability can also be higher.
• A right-down-the-middle, moderate approach, which seeks to find a
balance right between the two. This is sometimes easier to do once your
business is up and running for at least a short period of time so you have
more flexibility.
It is not always easy to know exactly where your business fits unless you have a
solid understanding of your management accounts and the relevant ratios. PCI
can help you understand exactly where you sit and leave you with a suite of tools
to help you monitor the position moving forward.