Nowadays, cash is king. Letting it slip away is potentially terminal, especially a small or medium sized business. Getting a picture of your company’s working capital can provide excellent insight into how well it handles its cash – and whether it’s likely to have any. The better your company manages its working capital, the less you may need to borrow and the less you may have to cut costs to dangerous levels.
If the cash lifeline deteriorates, so does the company’s ability to fund operations. Understanding a company’s cash flow health is therefore essential. A good way to judge is to look at how you manage your working capital.
Working capital is the cash your business requires for day-to-day operations. It’s for buying raw materials and then funding every workflow and cost until those raw materials are converted into finished goods, which then have to be sold for payment. Inventory, accounts receivable and accounts payable are therefore vital life signs in determining financial health.
Take a food company as an example: The company uses 500 euro to buy ingredients. A week later, the company uses the ingredients and produces goods which are then shipped to a customer. Say 2 weeks later – if you’re lucky, the cheque arrives from the customer. That €500, which has been tied up for three weeks, is the company’s working capital.
The quicker the company sells its products and gets paid, the sooner the company can go out and buy new ingredients, which will be made into more produce sold. If the ingredients sit in inventory for a month, company cash is tied-up and can’t be used to grow the business. Even worse, the company can be left strapped for cash when it needs to pay its bills and make investments. The other big trap for working capital is when customers do not pay their bills on time or indeed when you pay suppliers in an inefficient way ie too quickly or maybe not fast enough thereby incurring late fees.
You need to make sure that trade terms trade terms are optimised. If you’re selling to a supermarket chain, you’ll understand what this means. The number of days outstanding for the payment of invoices ie the number of days that your company takes to collect payment after making a sale, are a good indication as to the efficiency of your working capital management.
If those days begin to stretch, its a sign of trouble because it shows that a company is taking longer to collect its payments. This could mean that you’re not going to have enough cash to fund its short-term obligations because the cash cycle is lengthening. If you’re already low on cash, this could be catastrophic.
You also need to keep a keen eye on inventory and how fast or slow its moving. Remember all of those ingredients or raw materials are tying up your cash.
Broadly speaking, a high inventory turnover is good for business. Products that sit on the shelf are not making money, unless your gearing up for an anticipated increase in business. However be careful here. Even the best in the business can get this wrong and in unexpectdly warm winters, for example, you will see a lot of sales in gloves, scarves, umbrellas.. as retailers desperately try to move inventory and free up working capital.
As mentioned at the start, cash is king, especially in recessionary times. Analysing your company’s working capital can provide excellent insight into how well its doing and whether or not it can survive and prosper through the credit crunch.