Working Capital – why is it so important?

Working Capital – what is it?

Working capital is essentially the cash (liquidity) that you will need to run the business. It is important to understand as it is the life-blood of the company, particularly during the start-up phase; and during a [rapid] growth phase of the business, as more liquidity is likely to be required at these stages of the business life cycle.

In accounting terms, working capital is the difference between current assets and current liabilities – A large amount of working capital (>1) means that the assets of the company are more than sufficient to cover the current (due within a year) liabilities. A small (<1) amount of working capital means that the company may not be able to pay even by turning those assets into cash.

This may sound similar to cash flow, however, working capital is broader than that – cash flow refers to the amount of cash a company generates (or requires) within a specific period of time. Working Capital is a measure of the company’s liquidity, efficiency and overall health.

Working Capital – what is there to understand?

The important aspect for owner managers is to understand the working capital requirements, particularly at start-up and during periods of [rapid] growth. For example, during start up there will be many costs to get the business up and running, typically, labour or stock ready to build and complete orders.

In a worst case scenario [from a working capital perspective], a larger than expected order comes in, from a large corporate insisting on 60 day payment terms. How do you finance this? It is likely that you will have to pay your employees 3 sets of monthly salaries before the invoice is settled; You have had to fork out for the stock which may have to have been paid up front as you are a new company with no credit history….

This is a similar situation businesses find themselves in during periods of rapid growth or during seasonal peaks where the company’s cash position is being stretched. As an owner manager of a small business, it is important you foresee this issue and plan ahead, so that you are able to finance your way through the situation. There are a number of options to finance this type of situation, the more common ones are:

Personal funding

In the current climate the easiest way to finance a start-up is through your own personal funds, or funds of a family member in return for some equity in the business under agreed terms

Bank Overdraft

For some start-ups (usually well capitalised) and certainly for established business, an overdraft facility may be more appropriate. The advantage of an overdraft is that you borrow, depending on your facility limit, the amount that you need at that point in time. You also have a level of [liquidity] insurance if you can extend the limit beyond your current known requirements in case another large order come in.

Invoice Discounting or Factoring

Another option to consider is invoice discounting or factoring where a bank or other financial company buys the invoice from you once you have fulfilled your order. They pay you slightly less than the invoice amount straightaway and they then chase the amount owing. This tends to be more expensive that the Bank overdraft but some businesses find this financing tool more convenient.

Trading Terms

For established businesses and near start-up with some trading history, you may be able to extend the terms with your suppliers. Typically, this should be easier with larger companies as your smaller suppliers are likely to have similar cash issues. You may be able to extend your terms to 60 days from 30 days for a short period of time. This will be much easier to agree if you have kept up a good payment history with them.

[There is more detailed information in other CMC Blogs specifically raising finance]

One principle I would apply is that in general, keep working capital financing short term, and leave the longer term loans for financing assets.

Working Capital Requirements

To help understand working capital requirements, it is necessary to evaluate the worst case scenarios (end to end), in terms of days to build your product added together with the payment terms. Working with one of my manufacturing clients we have reduced this from 16 to 8 weeks which has made a substantial difference to the working capital requirements.

In summary, the working capital has a direct impact on the cash flow within a business, and with cash being ‘king’ and being able to make or break the business, it is vital that as an owner manager, you have a good understanding of working capital requirements for your business, especially during times of rapid growth..

If you would like more information about this subject or would like discuss any aspect in more detail please contact me via the form below.

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