It is only too true that expenses tend to outstrip income at the start of a business venture and only too few, if any, new businesses are profitable as soon as they are launched. It takes time for a business venture to reach its break-even point and to start making a profit. Hence, keeping a tight control on working capital is essential for entrepreneurs who are focused on a long-term horizon, as a sustainable business can only be built on efficient working capital management systems.
Before diving deeper into the vast domain of working capital management, it is important to define precisely what constitutes working capital. To put it simply, working capital refers to the funds needed to carry out your recurring and routine business operations. It allows you to meet your short-term debts and operational expenses as they fall due, which can be particularly important for start-ups and growing businesses.
"Working capital...allows you to meet your short-term debts and operational expenses as they fall due..."
Thus working capital management is the process of managing activities and operations related to working capital. The management of working capital involves managing inventories, accounts receivables, accounts payables and cash.
The goal of working capital management is then to place the company on a firm footing to continue its operations and enable it to meet both short-term obligations and operating expenses as and when they fall due.
Let's go a little bit deeper into this.
1. Working Capital Cycle
A good metric to evaluate the efficiency of working capital management is the duration of the working capital cycle. A working capital cycle measures the time taken from receipt of raw materials from supplier to realization of cash from debtors. It is in the interests of the organization to keep its working capital cycle as short as possible to ensure that cash is received into the business with minimum delays, and can be used to fund the next sales opportunity. The shorter the turnaround time for a transaction from purchase to receipt, the more the number of sales opportunities that can be met in a given period.
The working capital cycle consists of the following elements:
Cash (funds on hand)
Creditors (accounts payable)
Inventory (stocks on hand); and
Debtors (accounts receivable)
2. Elements of Working Capital
Working capital consists of four elements – cash, inventory, debtors and creditors.
Have you ever faced a stretch because of inability to meet payments based on current cash flows? No wonder then, if you ask anyone who manages their own company, they would tell you without hesitation that cash is king. When it comes to your own business, sales are important, yes, but making sure that you get paid in time for what you’re selling is equally, if not more, important.
To highlight the importance of cash to a growing business, many entrepreneurs have told us that while their sales increased year-on-year, they still lacked funds to cover their overhead costs. Ultimately, inadequate credit and collections policy were found by our team to be the underlying cause.
At the outset, it is important to reiterate that inventory/stock purchases are part of the cash cycle or “operating cycle” of any business. First, the company makes payments to suppliers and then receives the stock (supplier days or payable days). Next, the stock is processed –depending on whether it is finished/ready to sell stock or raw materials that will be part of the production cycle – so the processing time should also be factored into the operating cycle. Finally, a critical component of the operating cycle of a business are the sales terms, whether on cash or credit terms. Hence the nature of the inventory, order amount, payment terms, time of receiving the stock, and processing time should be evaluated against sales and collection of monies from customers (receivable days) so that you can accurately assess your operating cycle and your business does not face cash shortages.
Managing payments to your suppliers could easily be the biggest worry you face while running your growing business, especially if the supplier has more bargaining power than you do. And, higher bargaining power on the part of your suppliers is an eminently possible scenario when yours is a small business that is just beginning to spread its wings, while your suppliers are established business houses that have been dealing with the cut-throat corporate world for many years.
Another important aspect of account payables management is to manage your relationship with your suppliers in an optimal manner. Considering that stock is the lifeblood of any business, any path that causes your relationship with your suppliers to take a hit is clearly not to be pursued.
It is seen only too often that companies react to a temporary cash crunch by asking their accounts payables department to stretch payments to their suppliers, considering that payments to ‘inflexible’ creditors such as the bank and taxation authorities are regarded as sacrosanct. However, this “solution” can prove to be costly in the long run, by causing your suppliers to tighten your credit period, or to cease giving credit to you altogether.
How then, can you manage payments to your suppliers in a manner that ensures that you enjoy the grace of the full credit period provided by them, while at the same time avoiding costly penalties by inadvertently missing out on paying your bills in a timely manner.
As part of our business support function, we counsel entrepreneurs on how to find the balance between meeting their payments on time, while still managing to keep cash in their business for as long as possible.
You won a big order from a reputable client, managed to ship the goods on time and heaved a sigh of satisfaction at successfully closing an important sale. We know the temptation to pat yourself on the back is great, but the job is only half done – the money still hasn’t found its way back into your business. Bottom-line: until you get paid by your client, the sale is not closed.
Indeed, we often hear clients saying that sales are up but they encounter cash flow problems as a result of the very sales that they have made – on credit terms. Customers pay late, or, in some cases, not at all, effectively ensuring that the money has not yet been received against sales made but cash has already been paid by the entrepreneur to buy the goods meant for sale.
In effect, collecting money from customers can be one of the toughest tasks that your business faces, especially when it is an entrepreneurial venture where timely receipt of monies from your clients can mean the difference between paying your staff their salaries, and telling them to wait yet another month till payday. In the worst case, delayed payments from your customers could force you to re-negotiate and stretch payments to your own suppliers, causing your creditworthiness to take a nosedive.
Also, it is at times noted that entrepreneurs become victims of their own success as they go on to win big-ticket orders from ‘trophy’ clients, essentially large companies with great market reputation and strong market clout. Getting flooded with large orders from such trophy clients could give your business great mileage and add several successful case studies to your marketing suite, but it could also mean unwarranted delays in payment amid an inability to bring pressure to bear on such sensitive and valuable clients. It is often seen that such sales wins culminate in over trading, as big clients demand stretched credit terms which are invariably more favourable than supplier terms. This, taken together with additional funds that need to be injected into the business to execute such big orders, is likely to lead to cash flow constraints for the entrepreneur
How can Wylde help you?
With our thoughtfully designed and well-structured suite of finance support services, Wylde International will help you add value to your business in the critical area of cash management.
Coupled with our unique value proposition of long term commitment, Wylde equips your business with the working capital management systems to make it sustainable over the long term. In additional designing customized finance support services to meet your needs at the different growth stages.