Cash is always king in a business. Managing it effectively can be a delicate balancing act but one that is crucial to the good health of the enterprise.
It’s about solvency. Having sufficient cash on hand at any time for the business to pay its bills and be able to operate on a day-to-day basis. Accountants define working capital as the ratio between current assets and current liabilities. That means, on the one side, cash in the bank, amounts customers owe the business and stock or “inventory” that can be turned into cash at short notice. On the other, side it’s obligations to pay suppliers, salaries and meeting other immediate obligations.
The exact ratio varies from business to business but if the number is less than one, this is termed “negative working capital” and suggests that the business is not sufficiently solvent—that is to say healthy from a cash point of view. A ratio of more than two may imply that there is too much cash slushing around, which may not be being used to best effect.
It follows therefore that carefully and effectively managing both sides of the equation are useful skills. There are three key areas:
Income
Our recent post on late payment goes into some detail about how to run a tight ship when it comes to making sure customers pay their bills. However, before you get to actually selling something on any other basis than cash in advance, credit assessment is a vital step.
This is about figuring out whether potential customers are able to pay for the goods or services they want to buy from you and existing customers will continue to pay their bills. Credit checking customers is a whole subject in itself. Essentially it’s about considering their business in the round and getting a handle on their track record, to reach a point where it looks sensible to sell to them.
The longer you give them to pay, let’s say at 30 days, 60 days or in some cases even longer, the more rigorous the credit checking process has to be. The key point here for working capital purposes, is that the longer the credit period conceded to a customer, the longer the period that cash has to be found to meet the outgoings before payments come in.
Photo by Liudmyla Denysiuk on Unsplash
Outgoings
This is a mirror image of customer credit assessment. Instead of looking at whether they will pay their bills, it’s about answering the question: “Will they deliver?” Will they supply the goods or services your business needs to operate? Will they, for example, supply the components needed to make the goods you are in the business of making and selling?
Importantly, there is a credit issue here as well. Are they financially sound? If your supplier goes out of business your business will be impacted.
At the same time, if you can obtain credit terms that are at least as good as those you concede on the sales side, you are more likely to be cash positive. For example, if you had to pay your bills at 30 days but sold your products on 60-day terms you would somehow have to finance the 30-day difference between the two, perhaps by means of a bank overdraft or invoice discounting which has a cost attached to it.
However, just suppose you were able to pay your suppliers on, say, 60 or 90-day terms and receive cash on the nail from your customers, that would be an elegant way to garner up cash to run the business with.
But there are some elements to outgoings that are crucial and non-negotiable. These include, among other things, paying employees, collecting and paying VAT, meeting National Insurance and corporation tax obligations, keeping the lights on at the factory, the warehouse or the office. Without these the business can probably not function on an on-going basis.
Inventory
Meanwhile, in many businesses, cash is tied up in stock or inventory.
Stock enables a business to make what it sells and supply what customers want, in a timely manner. The cash flow implication is that there is a cost to paying for components and holding them in reserve before you turn them into cash through sales. There is also the cost of storage, the rent of a warehouse for example. No wonder then that major car producers discovered years ago that sourcing just-in-time components and assemblies made economic as well as functional sense. They no longer needed to hold large and expensive inventory to make their products. Inventory is a drag on cash in a business therefore and needs to form a part of the working capital balancing act that entrepreneurs and managers need to perform.
Virtuous circle
In brief then, cash remains king. Get it right, and incoming cash flows of the right size, at the right time should, added to healthy profit margins, fuel a successful, solvent business that can sustain its stocks, meet its obligations and produce a worthwhile surplus. That’s what effective working capital management is all about.