Managing working capital effectively is an essential business discipline, regardless of the stage of business’ life-cycle you have reached. During a start-up or growth phase, many businesses grow rapidly, run out of cash and fail. They simply do not keep pace with the business’ increasing cash needs. Established businesses must also pay close attention to cash flow and maintain adequate working capital to pay suppliers and expenses as they fall due.
In my experience, business owners often overlook two essential questions when addressing their working capital needs. Firstly, how much they require and secondly, how they will finance or fund it. Determining your business’ “cash conversion cycle” is often a good indicator of your working capital needs. It’s determined by calculating how quickly your business converts its purchases (materials, inventory, etc) into cash received from customer sales.
Managing Working Capital Effectively
You can use other working capital ratios or measures to review working capital needs. Ratios such as inventory turnover, creditor days, and debtor days can be used to help identify potential concerns or trends. Regularly reviewing them will help you prevent inadequate liquidity and cash flow and enable you to take proactive action before it’s too late.
Adopting “better business practice” will help you manage cash receipts from debtors (also known as “accounts receivables”). Providing easy payment methods, developing and adhering to credit policies, and following up on late payments will all help. However, you’ll need to consider any possible negative effect these may have on your customers. For example, customers may go elsewhere if your credit terms are unfavourable to them.
Paying close attention to paying your suppliers and expenses (“accounts payables”) is equally as important. Pay invoices when they are due (rather than paying early); check invoices for accuracy, negotiate credit terms, and utilising any prompt payment discounts will all help. Remember that in doing so you’ll need to ensure that your suppliers continue to supply you with materials, utilities, etc.
Economic Order Quantity
For many business, an important area of good working capital management is in managing inventory. Determining optimum stock levels and the ideal time to re-order inventory will help preserve cash. The “Economic Order Quantity” (EOQ) calculation will help you to determine how much inventory you need. It will help you to balance “holding costs” (warehousing space, etc) with costs associated with ordering stock (“delivery charges, etc). EOQ will also help prevent you running out of inventory by determining “safety levels”.
Irrespective of whether your business is a start-up or not, managing working capital effectively will be vital to your success.