[Updated 2 February 2022]
Good working capital management is vital to succeed in business.
Simply put, working capital is the cash you generate or you need to cover your expenses. Although it’s relatively easy to explain, it’s continually changing. This makes applying it to your business even more challenging.
Even successful businesses owners experience anxieties with their working capital.
Working capital management is an effective strategy that has significant potential to guarantee you’ll enjoy long-term success. This article discusses how to manage your working capital so you can sleep well tonight.
The Working Capital Cycle
The working capital cycle refers to the time it takes to turn your service or product into cash.
When your working capital cycle is too long you’ll require more cash, while you wait to be paid. But you’ll still need to pay expenses, such as rent, salaries, loan repayments while you wait.
It’s essential you know what cycle you operate on to determine how much working capital you’ll need.
For example: hairdressers receive their cash immediately and have a short cycle. Compare this to avocado growers who operate on a seasonal basis. They have a longer cycle – often needing to pay pickers, rent, etc before they are paid.
Determine how much cash you’ll need to have on hand or easy access to. A good-rule-of-thumb for many businesses is to have enough to pay two or three months expenses.
Assess Your Working Capital Management
Having a profitable business is not the same as having cash in the bank. When you are paid will often be different to when you need to pay your bills.
The following strategies will help you manage your working capital:
- Make it really easy for your customers to pay you. Consider using mobile payment methods that banks currently promote. And make sure you always add your bank details and payment terms on your invoices.
- Reduce stock levels and order wisely. Buying in bulk to obtain bigger discounts might be tempting. But remember you need to turn your stock into cash. Sell obsolete and slow moving inventory. Compare your stock-levels with industry benchmarks.
- Delay or avoid buying expensive plant and equipment with cash. Look at other options, such as loans or leases to spread repayments over several periods.
- Be careful not to over-trade. A big order from a new customer might sound appealing. But if you’re running at full-capacity or need to increase your expenses, your cash reserves can quickly run out.
- Avoid large unplanned drawings and check whether your business needs the cash more than you do.
Shorten Your Cycle To Improve Your Working Capital
It’s critical you review the quality of your working capital. How long do your debtors take to pay you? What payment terms do your suppliers give you?
Collect what you are owed promptly. Ensure your systems and processes identify slow payers and you take appropriate action when required.
We’ve written many articles on how to ensure you’re paid on time.
Review your credit terms. Are they reasonable or are they damaging your cash flows? Do you offer better and longer terms than your competitors?
Talk with your suppliers. Could you negotiate betters terms? Remember, if you’re paying your bills on time but your customers aren’t, your working capital will be under much greater stress.
Maintaining up-to-date cash flow forecasts will undeniably help you manage your working capital more effectively. It’s key to managing a successful small business.
Good cash flow management will help you forecast future surpluses and shortages. You’ll be better placed to make more informed decisions around meeting loan repayments, tax liabilities, and other expenses and if you can afford new equipment.
Working Capital Formula
The working capital formula indicates your ability to pay your bills on time.
It’s calculated by dividing your current assets (such as cash on hand and at the bank, stock, debtors) by your current liabilities (including unpaid bills, tax liabilities, etc).
If your current liabilities exceed your current assets you may have a problem if you don’t address it.
You should consider seeking professional advice – either from your bank or accountant. They will be able to work with you to develop a working capital management strategy that suits your needs.