Intro to Working Capital Management

It seems like everyone is constantly talking about how important “working capital” is for your small business these days. The topic is everywhere: national TV commercials, morning radio shows, daily newspapers, your local bank branch and White House briefings. Even your kids may be giving you advice at this point.

Working capital is undoubtedly crucial for any small business, but for those of us who are not financial experts, figuring out a sound strategy for managing our working capital can be a daunting task, especially when we are getting bombarded with a constant stream of advice from literally hundreds of random sources. As a result, figuring out the most affordable and the most effective methods to manage working capital may sometimes be more difficult than actually running our business.

In a new series of articles beginning with this post, we will compile, refine and simplify all the crucial things you need to know to better manage — and to quickly improve — your working capital, so that you can go back to growing your business. With practical tips, real-life examples, and step-by-step instructions, we will share the best practices around working capital management in an easy and understandable format.

WORKING CAPITAL & ITS MAIN ACCOUNTS

According to the Small Business Administration, insufficient capital is one of the major reasons why small businesses fail. Very broadly defined, net working capital equals current assets minus current liabilities.

Net Working Capital = Current Assets – Current Liabilities

Current assets and current liabilities include four accounts that are crucial for working capital management:

– Cash
– Inventory
– Accounts Receivable
– Accounts Payable

It is important for businesses to understand how best to optimize the relative sizes and turnover rates of these accounts. Depending on the industry, business size, location, and other individual factors, there can be great variation in methods and suggested approaches to optimization. Nevertheless, the basic strategies for managing these accounts are quite comparable. So let’s take a brief look at each one of them:

CASH

Your cash balance is what pays your bills every day; therefore, making sure you have enough cash to get through your sales cycle is critical. The inability to pay bills, loans, or other expenses can really put a lot of pressure on a business. By focusing on cash generation without increasing your liabilities, you can significantly improve your working capital. Advances, bank loans, and other forms of debt will increase your liabilities. Though you may increase your cash today, you will strain your working capital down the road. That’s why most of the time the cheapest way to access cash is through sales. Therefore, businesses extending net terms to customers find accounts receivable become the major source of their cash balance.

INVENTORY

Inventory is really nothing more than “tied up cash”. You need continuous production with minimal investment in raw materials and minimal reordering expenses. This is mostly an operational balance that every business needs to strike on a case-by-case basis.

Balanced inventories are important because many businesses rely on their stocks of items to make a profit. Stockpiles that never move from the shelves, however, do little good for the company. A proper balance is crucial for the health of your business.

ACCOUNTS PAYABLE

This is what you owe to your suppliers but have not yet paid. You will inevitably have to pay them one day, sooner or later. Your ability to pay suppliers depends entirely on your ability to manage your working capital. Businesses rarely have much real flexibility when it comes to accounts payable: you can stretch your payments, but they always show up on your ledger.

The type of financing option you decide to go with usually determines the terms of your accounts payable (e.g. short term vs. long term, structure of the debt instrument, price, etc). Financing your operations is a critical component of your business and the financial choices you make will determine most of the stress on your working capital. Yet, there is only so much you can do after getting a loan or receiving an invoice from your supplier.

ACCOUNTS RECEIVABLE – YOUR MONEY

This is money customers owe you. You have already earned it and, unless you find a way to effectively collect it before it is too late, it might cost you your business. According to the premier business blog allbusiness.com, effective accounts receivable management tools to reduce those delinquent accounts are especially vital in this tough economy. If you don’t get paid by your customers, you will most likely be in deep trouble. There is a reason why “insufficient capital”, which is to say, money, is one of the main reasons why over half of all small businesses don’t make it past the first five years (see article here).

Unlike the other critical accounts we included in our definition of working capital above, accounts receivable is the one area that is most likely to give you a significant boost if you follow a number of practical actions. Most small businesses do not have effective accounts receivable management policies. They are neither aware of the solutions that will help them convert receivables into cash, or of methods that will help them simply to collect their payments from customers. In our future articles, we will explore in detail the best solutions businesses can use to better manage their receivables, including:

– How to reduce days sales outstanding.
– When to outsource receivables.
– How to determine if it is the right time to sell receivables.
– How to minimize risk and better manage delinquent customers.

We leave you with a simple illustration of the crucial role of accounts receivable for any business:

Assume you are a small business making $2 million in sales with a 10% profit margin. If 5% of your accounts are delinquent ($100,000), then you will need to make an additional $1 million ($100,000 = $1 million in sales x 10% profit margin) in sales (50% more over the current $2 million in sales) to make up for the lost profit!

Which one do you think will be easier for you and your business: increasing your sales by 50% or learning to better manage your delinquent accounts?

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