Irrespective of the stage of a business’s life cycle, managing working capital is extremely important. During the growth phase, many businesses have failed due to growing too rapidly, and not having the corresponding cashflow to keep up with the expanding needs of the business. Meanwhile, mature businesses need to maintain sufficient working capital to ensure funds exist to meet liabilities as they fall due and to take advantages of business opportunities as and when they arise.
There are two fundamental questions an organisation should ask itself when managing working capital. The first is how much working capital is required and the second is how should it be funded?
A good indication of the working capital requirements of a business can be determined by the ‘cash conversion cycle’. This is the length of time from the purchase of inventory or materials to the receipt of cash from customer sales. The length of this cycle can be influenced through the management of debtors and creditors.
Other financial measures that can be used to monitor working capital requirements include debtor days, debtor turnover, inventory days, inventory turnover, creditor days and working capital days. Monitoring these types of ratios over time can help identify problems before they manifest themselves in other more damaging ways, thereby enabling pre-emptive action to be taken.
Tangible ‘best practices’ that can be adopted to manage accounts receivable, i.e. cash inflows, include establishing a credit policy, making invoicing clear to facilitate payment, invoicing earlier, reducing payment terms, following up on overdue accounts, offering early settlement discounts and stopping credit to debtors that don’t pay. Such practices need to be balanced against their potentially negative impact, such as customers going elsewhere because of unfavourable credit terms.
Conversely, managing cash outflows is also important by taking advantage of early payment discounts, prioritising suppliers, only making payments when they are due, ensuring invoices are checked for accuracy before payment, negotiating extended credit terms or putting procurement practices in place that are price driven, not relationship driven. However, care needs to be taken to ensure continuity of supply of materials and inventory.
Finally, inventory management is an important aspect of working capital. Techniques can be utilised in order to determine the optimal level of inventory a business should hold, and the ideal re-order point. A common model that is used is the ‘Economic Order Quantity’ model which determines the optimal amount of inventory a company should order by balancing ordering costs and carrying costs. Other considerations also include calculating the optimal re-order point so as not to run out of stock, and the consideration of holding ‘safety stock’ to avoid shortages.
Whether your business is starting up or well established, managing working capital is integral to success.