• October 21, 2021
• By Rick Arthur
• In Growth, Working Capital
• No Comment
• 1

Two important financial goals in business are to make a profit and generate cash flow – both necessary for growth. Cash, in its purest form, is currency or exists electronically in your bank account. Think of Working Capital as how cash is converted, or flows, to other current assets – Inventory and Accounts Receivable – so your business can develop products, sell them, and make a profit.

While profit is the best source of cash and internal Working Capital, it takes not only good profitability but also good management of Working Capital to ensure sufficient cash for growth, or in some cases, to remain operational. Management of Working Capital involves converting non-cash assets back into cash, quickly and efficiently. Three components of the Cash Conversion Cycle come into play: Inventory, Accounts Receivable, and Accounts Payable. Let’s explore each in more detail.

Inventory

The faster you turn inventory, the less cash you must invest. Too much inventory ties up cash, too little results in lost sales. Here are a few tips for managing inventory:

• Forecast inventory requirements based on forecasted sales or history.
• Factor in lead time for receiving inventory.
• Consider safety stock to eliminate stock-outs.
• Know your Profit Margin by stock item.
• Delegate purchasing responsibility to a qualified manager.
• Cycle count your inventory.
• Review inventory stock items regularly to eliminate slow turn of low profit items.

Accounts Receivable

It is important to remember that Accounts Receivable is the last step before this asset is converted back to cash. If you loosen credit to generate new sales and never collect some of the Receivables, there is a two-fold effect on working capital – it is never collected (i.e., no cash) and you have lost inventory. Profits come only from paid sales so not every sale is a good one! Consider these tips for managing Accounts Receivable:

• Develop effective credit policies and processes.
• Establish credit limits by customer.
• Send invoices immediately – when orders are shipped or services are rendered.
• Accept ACH, credit or debit cards.
• Document collection policies and processes, including clearly identifying responsibilities of team members who fill these roles.
• Immediately resolve customer service issues that may impact invoice payment.
• Consider e-commerce sales with a merchant account (no accounts receivable).

Accounts Payable

While the goal for Accounts Receivable is to collect quickly, the goal for Accounts Payable is to stretch payment within the terms of your agreement to retain the use of this asset for as long as possible. Here are tips for managing Accounts Payable:

• Select vendors that will have a positive impact on your inventory management.
  • Ship complete orders on time.
  • Honor negotiated prices.
  • No partial payments of incomplete purchase orders.
  • Provide minimum 30-day notice of price increases.
• Have more than one vendor for critical inventory items.
• Document the process for Accounts Payable approval and payment.
• Do not pay invoices early.

Working Capital Strategies

In addition to the actions you can take to manage internal Working Capital, strategies to improve Working Capital are important as well. Some of the main considerations are to never use Working Capital to purchase long-term fixed assets. These should be purchased using term loans or leasing. Additionally, consider re-financing existing fixed assets (equipment, etc.) and potentially obtaining an equity injection, either from the business owner or the sale of stock.

Without sufficient Working Capital businesses can fail, even during times of increased revenues and profit. Calculating the required Working Capital for growth serves as a guide in terms of whether you need external, or borrowed, Working Capital or need to temper your growth within the limits of your internal Working Capital.

To calculate current Working Capital Review your latest Balance Sheet: Current Assets minus Current Liabilities. Next, calculate your current required Working Capital: Average Daily Sales X Cash Operating Cycle in Days. If your requirements are greater than your Current Working Capital, you will need to make decisions to ensure you have enough cash. For growing businesses, calculating the amount of WC required to fund the growth is the same calculation as above, but using your forecasted pro forma Balance Sheet and Income Statement instead of historic numbers. Watch my short video to learn more.

I’ve received numerous questions recently about external funding of Working Capital. Next month’s blog will look at options and considerations for external sources of funding. In the meantime, please contact me if you have questions about internal management of Working Capital or would like to discuss how I can help you optimize this vital financial resource or refine your processes.