One of the indicators of a business’ financial health is its working capital. Having no working capital means you may not be able to pay your bills on time, which, in turn, may incur interest or penalties. In the long-term, insufficient working capital can harm business relationships and gradually run the company into the ground.
Working capital is not just cash, which may be easily and quickly used for investments, but rather a more complex web of cash, receivables, inventory and accounts payable that measure a company’s short-term, net financial health and performance.
There are many reasons why a company might have a low level of working capital, but those can all be reduced to the four components mentioned above.
Consider a scenario where a company is low on cash and accounts payable show an uptick; in that case, the company would quickly turn to its receivables and attempts to recover money from its debtors. With a somewhat liberal credit policy toward its customers that offers long payment terms, a company may find itself low on liquidity. When there are too many high-amount, past-due receivables, a company might have to make a choice between staying solvent and facing a downward-spiraling situation. Check out one of our past articles on accounts receivable for a more in-depth view of how to Prevent Non-Payment of Bills for B2B Transactions.
Inventory management is another essential part of controlling the company’s working capital. Reconciling the need to maintain an inventory with an efficient, customer-oriented production process flow takes not only a comprehensive set of steps and product stock analysis but also a deeper understanding of how overstocking and understocking impact the company’s operating liquidity.
Next, we’ll take a closer look at several specific behaviors that may threaten the working capital of a business and at alternative choices that can lead to a better outcome.
The Problem: Paying Bills the Moment They Arrive
When it comes to paying bills, your instinct might be to pay them as soon as they arrive. This avoids costly late fees, bad credit scores, and prevents you from accidentally spending money meant for your accounts payable.
Paying bills the moment they arrive, however, may end up reducing your working capital until you suddenly find yourself with negative liquidity.
The Solution: Create an Invoice Calendar
When you receive an invoice from a supplier, check the due date. Many suppliers give customers 30-60 days to settle their bill.
Create a calendar of your invoice due dates. Be sure to set reminders at least 24 hours and up to a week in advance so that no due dates sneak up on you.
Having this calendar of invoice dates will help you see which invoices have to be paid right away, and which can wait. This allows you to manage your working capital better by spending only the money you need to pay out right now and saving the rest until you gain more income.
The Problem: Delaying Customer Payments
As a business owner, you might allow your customers to delay payment or pay in installments. This is not only an attractive option for your customer base, but it can also make you more competitive with similar businesses.
If you delay customer payments for too long, this could have a negative impact on your working capital. If your income is still pending while you have bills coming due, you could suddenly find yourself without capital with which to pay the ever-mounting debts.
The Solution: Collect Deposits
To avoid this scenario, require deposits upfront. The deposit should be somewhere between 10-50% of the selling price.
When calculating the percentage to ask for, make sure you will generate enough income to cover your bills.
Create a customer payment plan that is less than the time you have left to settle your own payables (for example, if a retailer gives you 60 days to pay an invoice, you should give your customers 30 days). Our article, How Data Analytics Can Help Your AR, offers some useful information on how to use data analysis to optimize collections.
The Problem: Unforeseen Shutdowns
Unforeseen circumstances can cause businesses to shutter operations and lose days, weeks, or months of revenue. These circumstances range from natural disasters to a global pandemic; still, even a family illness can halt all operations or significantly impair them.
If you have poor working capital management, even one day of lost revenue could have long-lasting consequences.
The Solution: Start a Rainy Day Fund
A Rainy Day fund is a cash reserve set aside in case regular forms of income suddenly stop.
While there are many ways to create your fund, the best way is to open a savings account, preferably one that accrues interest over time. This account should be separate from any business accounts, and few people should have access to it (you don’t want a rogue actor inside your business to wipe it out).
The amount of your Rainy Day fund is up to you, but after seeing the longevity of the effects of COVID-19, having a reserve of at least one month of expenses is wise (meaning you have enough cash to pay your bills and your employees without any revenue).
Add to this fund every month or quarter, to ensure its growth and provide yourself with a greater financial cushion should the worst happen.
The Problem: Ageing inventory
In instances where companies overstock because of an upward trend in the market, faulty analysis or out of sheer optimism, there are several downsides that should make any business owner and inventory manager pause: the costs of storage, inventory tracking, long-term maintenance, increasing irrelevance of the current stock to the market, inability to bring new inventory that meets the demand of the moment, and stagnant customer engagement.
The Solution: Inventory Segmentation and Customer Re-engagement
An inventory is only as good as its shelf-life, and that means that the sooner it is loaded onto a pallet and leaves the warehouse, the better off the company is.
Supply and demand are two simple words given to what are actually complex market forces. Inside that market of constant exchanges, estimating and controlling inventories efficiently are vital to survival.
There are various ways to segment products based on a business’ profile and organization: obsolete, updated/refurbished or totally new; slow, moderate, or fast-moving; high- or low-priced items, or by level of cost per unit, etc.
For an aging inventory, the best way to segment is by product life cycle: obsolete vs. in-demand products.
One strategy to use obsolete products so they’re not a total loss is to repurpose or upcycle them. Another is finding niche customers or organizations that cling to an outdated way of doing things and who might still be in need of the product. A third one is renewing relationships with customers who bought the product in the past and assess their current need for your inventory.
Working capital doesn’t have to be a complicated part of doing business. With accurate data entry and just a few calculations programmed into a spreadsheet or software program, a company can be proactive and efficient at managing its capital. As long as it doesn’t spend too much of that capital to manage it!