The faster your business expands, the greater the need for working capital. If you have insufficient working capital – the money needed to keep your business functioning – your business is doomed to failure. Many companies that are profitable on paper are forced to “close their doors” because of their inability to meet short-term debt when they mature. However, by implementing sound working capital management strategies, your business can flourish; In other words, your assets work for you!
At some point, most companies need to borrow money to finance their growth. The ability to get a loan is based on a company’s credit rating. The two most important factors that determine creditworthiness are the existence and extent of collateral and the company’s liquidity. Your company’s balance sheet is used to assess both of these factors. On your balance sheet, working capital represents the difference between current assets and current liabilities – the capital you currently have to finance operations. This number plus your key working capital ratios indicates your creditors’ ability to pay your bills.
By definition, working capital is a company’s investment in current assets – cash, marketable securities, receivables and holdings. The difference between a firm’s current assets and current liabilities is called net working capital. Current liabilities include receivables, accrued expenses and the current portion of overdue loans or leasing payments. The term “current” is generally defined as the assets or liabilities that will be liquidated during a business cycle, typically one year.
Decisions regarding working capital and short-term financing are called working capital management. These decisions involve managing the relationship between a company’s short-term assets and its short-term liabilities. The goal of Working Capital Management is to ensure that your business is able to continue its operations and that it has sufficient cash flow to satisfy both mature short-term debt and future operating expenses.
The real test of a company’s ability to manage its financial circumstances rests on how well it manages its conversion of assets into cash, which will ultimately pay the bills. The ease with which your business converts its current assets (receivables and inventory) into cash to meet its current obligation is called “liquidity”. Relative liquidity is calculated as a ratio — a ratio of current assets to current liabilities. The rate at which receivables and holdings are converted into cash affects liquidity. All else being equal, a company that has a higher ratio of current assets to current liabilities is more liquid than a company with a lower ratio.
Most business activities affect working capital either by consuming working capital or by generating it. A company’s cash passes through a number of stages in the working capital cycle. The working capital cycle begins with converting cash into raw material, then converting raw material into product, converting product into sales, converting sales into receivables, and finally converting accounts receivable back into cash.
The primary goal of working capital management is to minimize the time it takes for money to go through the working capital cycle. The longer it takes a company to convert its inventory into receivables and then convert their receivables into cash, the greater the cash flow difficulty. Conversely, the shorter a company’s working capital cycle, the faster cash and profits are realized through credit turnover.
Proper cash flow forecasting is important for successful working capital management. To understand the size and timing of cash flows, it is critical to map cash flows using cash flow forecasts. A cash flow forecast gives you a clearer picture of your cash sources and their expected date of arrival. Identifying these two factors will help you decide “what” you want to spend your money on and “when” to use them.
The management of working capital includes the handling of cash, inventories, receivables, receivables and short-term financing. As the following five working capital processes are interconnected, decisions made within each of the disciplines can affect the other processes and ultimately affect your company’s overall financial performance.
- Cash Management: Cash Management is the effective management of cash in a business aimed at putting cash to work faster and to keep the cash in applications that generate revenue. The use of banking services, lockboxes and celebrity accounts provides both the quick credit to funds received as well as interest income generated on deposited funds. The Lockbox service includes collecting, sorting, totaling and recording customer payments while processing and making the required bank deposits. A sweep account is a predetermined, automatic “sweep” – by the bank – of funds from your checking account into a high interest-bearing account.
- Inventory Management: Inventory Management is the process of acquiring and maintaining a proper inventory of inventory while controlling the costs associated with ordering, storage, shipping and handling. Using an economical order quantity (EOQ) system and Just-In-Time (JIT) inventory system provides uninterrupted production, sales and / or customer service levels at minimum prices. EOQ is a warehouse system that specifies quantities to order – which reflects customer demand – and minimizes total ordering and holding costs. The EOQ inventory system utilizes the use of sales forecasts and historical customer sales reports. The JIT inventory system relies on suppliers to send a product for timely arrival of raw material to the production floor. The JIT system reduces the amount of storage needed and lowers the dollar on inventory.
- Receivables management: Credit management enables you, the business owner, to manage the entire credit and collection process intelligently and efficiently. Greater insight into a customer’s financial strength, credit history, and payment pattern trends is critical to reducing your exposure to bad debt. While a comprehensive collection process (CCP) greatly improves your cash flow, strengthens penetration into new markets and develops a broader customer base, CCP depends on your ability to quickly and easily make informed credit decisions that create appropriate credit lines. Your ability to quickly convert your receivables into cash is possible if you execute well-defined collection strategies.
- Accounting Management: Accounting (APM) is not simply “paying the bills.” APM is a system / process that monitors, controls and optimizes the money a business spends. Whether it is money spent on goods or services for direct input, such as raw materials used to manufacture products, or money spent on indirect materials, such as office supplies or miscellaneous expenses, is not a direct factor in it. finished product is the goal of having a management system in place that not only saves you money but also controls the cost.
Short-term financing: Short-term financing is the process of securing funds for a business for a short period, usually less than a year. The primary sources of short-term financing are trade credit between companies, loans from commercial banks or finance companies, factoring of accounts receivable and business credit cards.
Trade credit is a spontaneous source of finance in that it derives from ordinary business transactions. In a predetermined agreement, suppliers send goods or provide services to their customers, who in turn pay their suppliers at a later date.
It is a wise investment of your efforts / time to regulate and establish a revolving line of credit with a commercial bank or finance company. In the event of a need to borrow cash, the funds will then be readily available. By arranging a credit line before the capital requirement (the cash requirement), your business does not experience sales or production interruptions due to cash shortages.
Factoring is short term financing obtained by selling or transferring your receivables to a third party – at a discount – in exchange for instant cash. The percentage discount depends on the age of the receivables, how complicated the collection process will be and how collectable they are.
A business credit card is quick and easy and removes approval of funds. Using your company’s credit card will also protect you from losses if you may receive damaged goods or not receive goods that you have already paid for. Depending on the type of credit card you choose for your business, you can earn bonuses, frequent flyers and cash back. But pay close attention to your expenses and pay most, if not all, of your debt each month.
To effectively manage working capital, it is prudent to measure your progress and control your processes. A good rule of thumb is – – – If you can’t measure it, you can’t control it. The five working capital ratios to help you assess and measure your progress are:
- Inventory turnover ratio (ITR): ITR = Cost of goods sold / average value of inventory. The ITR indicates how quickly you turn the stock. This ratio should be compared to your industry average. A low turnover ratio implies poor sales and therefore excess inventory. A high ratio implies either strong sales or inefficient buying.
- Receivables Revenue ratio (RTR): RTR = Net credit turnover / receivables. RTR specifies how quickly your customers return payments for delivered products / services. A high ratio means that either a company operates in cash or that its extension of credit and collection of receivables is effective. A low ratio means that the company needs to reassess its credit policies to ensure timely collection of transferred credit that does not earn interest on the business.
- Debt Settlement Ratio (PTR): PTR = Cost of Sales / Debt. Calculate this ratio to determine how quickly you pay your suppliers. If you consistently break the industry norm, you may have developed leverage that will help you negotiate discounts or other favorable conditions.
- Current ratio (CR): CR = Total current assets / total current liabilities. CR is primarily used to determine the ability of a business to repay its current liabilities (debt and debt) with its current assets (cash, inventory, receivables). The higher the current ratio, the better the company is able to pay its obligations.
- Quick Ratio (QR): QR = (Total Current Assets – Inventory) / Total Current Liabilities Also known as “acid test ratio”, QR predicts your current liquidity more accurately than the current ratio because it takes into account the time needed to convert inventory to cash. The higher the QR, the more fluid the company.
Managing working capital is critically important for small businesses because a large portion of their debt is on short-term liabilities versus long-term liabilities. Small businesses can minimize their investment in fixed assets by renting or leasing plant and equipment. However, there is no way to avoid investing in accounts receivable and inventory. Therefore, current assets are especially important to the owner of a small business. By effectively shortening the working capital cycle, you become less dependent on outside financing. In other words, your working capital really works for you.
Copyright 2008 Terry H. Hill: