Managing working capital
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 preemptive
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.