Working capital requires understanding

Enough working capital relieves stress.

Fail to understand working capital at your peril

Operational efficiencies and better working capital management will drive profitability, facilitate growth, reduce risk while improving sustainability. Improvements provide a genuine way to overcome your cash flow strain and sleepless nights. A business without working capital is like a car without petrol. It doesn’t matter how good the care is, it’s not going anywhere.

You must generate enough income to meet your operating expenses and service any debt while allowing for the growth you are looking to achieve. Lack of cash is the major reason why you need investors. You may have plenty of assets and don’t think working capital is important. This is confusing to many people and requires understanding.  Tracking the numbers are essential if you want to attract good investors and ensure financial viability. Keeping your business financially sound requires you to pay close attention to the financial data you are generating every day.

Working capital is a business health indicator

Working capital is used as a key indicator of the health of a business and its capacity to pay its bills as they fall due. Potential investors take a hard look at your Working Capital Ratio as a way to evaluate how much of your assets are liquid and how much are not. This is is the day-to-day money used to run the business and pay the bills.

The bigger the percentage of your assets as working capital the more liquid your business is.  The more you have, the better you can respond to changing business conditions. It also gives you peace of mind knowing you can pay your bills on time, every time.

Investors will check  your working capital to determine whether you can survive short and longer-term slumps in revenue.  Many lenders will require businesses to meet a minimum standard in order to qualify for loans and maintain a capacity to meet loan repayments.

There are substantial trade-offs between cash flow management, customer service, costs and risks. In order to optimise your overall management performance, you’ll need to recognise and understand these tradeoffs. Implement continuous improvement programs that take them these factors into account. It will require a holistic approach across the various functions of the business, including customer and supplier value drivers. 

There are many benefits to becoming financially savvy

Financially savvy people have agility. You think you should do everything in your power to become financially savvy in order to improve your agility. Sure you might have a good accountant or finance broker, but you need to understand the ins and outs of money as it affects your organisation. Failure to do so leaves you vulnerable and likely to have failures and miss opportunities.

Being financially savvy allows you to make good decisions about money. This is particularly so during a difficult time. It allows you to be quick on you feet and be able to take up opportunities in a timely manner. No more procrastination and losing out on deals and opportunities.

You may not have started your business to become a financial wiz. However, this should not be an excuse for not taking the time to understand the basic financial matters associated with an enterprise, http://goo.gl/5MfMnK.

How to determine your working capital

Working capital is used to fund debtors, inventory and business operations. Operations that are then converted into sales revenue for the business. Businesses with negative working capital may lack the funds necessary for growth, profitability and peace of mind. In some cases, negative working capital may be an indicator of a more serious problem.

It is always advisable to build cash reserves within your organisation. Financial business planning and tracking key financial indicators should be a part of the management plan, which is reviewed and analysed in a timely fashion.

Working capital = current assets – current liabilities.

How to determine your working capital ratio

Working capital ratio = Net working capital / Total assets

For example, if your total assets are $1,000,000, which includes your building, your vehicles, your inventory, your cash, everything.  Your working capital totals $400,000. $400,000 / 1,000,000 = .4, so your Working Capital Ratio is 40%. A very high turnover ratio can also show that a business does not have enough capital to support its plan for sales growth.

The working capital turnover ratio is an analysis tool. You can use it to determine the relationship between funds used to support operations and the sales resulting from such operations. Failure to establish the relationship can be disadvantageous to the operational efficiency of your business. Knowing the benefits of this ratio can help you use this tool more effectively.

Working capital turnover

The working capital turnover ratio is also referred to as, net sales to working capital. It indicates a company’s effectiveness in using its capital. The turnover ratio is calculated as follows. Working capital turnover = net annual sales divided by the average amount of working capital during the same 12 month period.

For example, if a company’s net sales for a recent year were $1,000,000. And its average amount of working capital during the year was $200,000, its working capital turnover ratio was 5 ($1,000,000 divided by $200,000). With this ratio, you can operate with a high degree of comfort. However, if your sales were $1,000,000 and the average working capital was only $80,000, the working capital would be 12.5. This means you would always be struggling to pay your bills and unable take advantage of payment discounts and other opportunities.

A measurement comparing working capital to the generation of sales over a given period provides some useful information. It shows how effectively a company is using its capital to generate sales.

The turnover ratio is used to analyse the relationship between the money used to fund operations and sales. In one sense, the higher the working capital turnover, the better the utilisation of funds. This means that the company is generating a lot of sales compared to the money it uses to fund the sales.

When used in an analysis of your business, the ratio can be benchmarked to similar businesses, or to your own historical turnover figures. 

What is a liquidity ratio

A liquidity ratio is an indicator of whether a business’s current assets will be sufficient to meet their obligations when they become due.

The liquidity ratios include the current ratio and the acid test or quick ratio. The current ratio and quick ratio are also referred to as solvency ratios. Working capital is an important indicator of liquidity or solvency, even though it is not technically a ratio.

Liquidity ratios sometimes include the accounts receivable turnover ratio and the inventory turnover ratio. These two ratios are also classified as activity ratios. 

What is the quick ratio

The quick ratio is a financial ratio used to gauge a business’s liquidity. This is also known as the ‘acid test’ ratio.

The quick ratio compares the total amount of cash + marketable securities + accounts receivable to the current liabilities. The quick ratio differs from the current ratio in that some current assets are excluded from the quick ratio. The most significant current asset that is excluded is inventory. The reason is that inventory might not turn into cash quickly. 

How do you improve your working capital

You can run your business at a loss for some time, but if you run out of cash you are in trouble. The impact of ineffective management of finance can be complex and can be debilitating for a business. Businesses with good capital management practices generate more cash from their businesses. They also have more flexibility to take advantage of opportunities as they arise and are less dependent on external financing.

The faster a business expands the more cash it will need for working capital. Your cheapest and best sources of cash exist within the business, but, prudent borrowings could be your best option. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of your problems with working capital and sales growth.

Each component of capital has two dimensions, time and money. If you can get money to move faster around the cycle you will improve your cash position. Collect debtors more quickly, reduce the amount of money tied up in inventory relative to sales. You could also sell off obsolete or underutilised equipment. The business will generate more cash and won’t need to borrow as much to provide an optimum level of working capital.

As a consequence, you could reduce interest costs and have additional money available to support sales growth. You could also negotiate improved terms with suppliers (get longer credit or an increased credit limit).  This effectively creates free finance to improve working capital and help fund future sales.

Take specific actions to improve your working capital

It can be easy to do some of the things listed here. But, expect some difficulties in implementation in the short term, but it will be worth the effort.

  • Limit spending, until the working capital ratio, is right for your business.
  • Try to tie every expense to generating profitable revenue.
  • Keep inventories low and dispose of slow moving stock quickly.
  • Sale of obsolete and underutilised plant and equipment.
  • Make more efficient use of your building facilities, rent out excess space.
  • Prudent low interest, longer term borrowings, could be your best answer.
  • Try hard not to tie up your funds in fixed assets when the business needs working capital.
  • Evaluate how hard your money is working for you.
  • Use technology to identify and help solve control weaknesses.
  • Make cost savings with improving productivity.
  • Improve collection through focusing accounts receivable management effort.
  • Make better, faster and more informed business decisions.
  • Monitor your key metrics weekly.
  • Use external advisors to help you.

It can be tempting to pay cash, if available, for fixed assets (vehicles, computers, plant, furniture, even new carpets). If you do pay cash, remember that this is no longer available for working capital. Therefore, if cash is tight, consider other ways of financing capital investments (loans, renting, leasing).

Similarly, if you pay dividends or increase drawings, these are cash outflows. Like water flowing down a plug hole, they remove liquidity from the business.

Quotable quotes

“The more capital you put into the business, the faster you’ll be able to grow and the more profitable your business can become”. Peter Sergeant

“Academic qualifications are important and so is financial education. They’re both important and schools are forgetting one of them”. Robert Kiyosaki

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