How to improve your working capital

Working capital is, in a nutshell, what cash you have each month to cover any expenses.

While it’s easy enough to explain, applying it to your business on a daily basis isn’t so simple, because it’s always changing. Even if your business is profitable, you can still experience working capital jitters. How do you manage and improve your working capital so you can sleep at night?

Understand the business cycle

A business cycle is the time it takes to manufacture a product or provide a service, then how long it takes to receive payment and finally, it landing in your bank account. So, the longer your business cycle, the more capital you’ll need, as you need to wait for payment. The trick is that often your fixed expenses such as wages and rent cannot wait to be paid.

For example, apple orchardists work via a seasonal cycle. They need enough cash to pay everyone to harvest and pack the fruit, before they’ll see a return at the end. On the other hand, a hairdressing business cycles cash through daily. Payment is often immediate, with only the monthly bills to track.

So when you’re deciding how much working capital you’ll need, it’s important to understand what kind of cycle your business runs on. 

Decide on a rule of thumb of how much cash you need in reserve. You can work this out by determining your production and overhead costs, as well as what credit and assets you have available. If you can also determine how long an interruption in cash flow might be, you can calculate how much you’ll need to keep doing business over that time. Many businesses have at least 3 months of working capital on hand; you could need more or less depending on your cycle circumstances.

Reduce your working capital needs

Just because your business is running profitably doesn’t mean the working capital takes care of itself. The timing of cash movements in your business and profitability don’t automatically flow together. In order to manage your working capital effectively, consider the following:

  • Avoid numerous or large personal withdrawals. If you have spare cash, double check your business doesn’t really need it first.
  • Don’t buy major assets out of day-to-day operating profits if it places stress on your capital. There should be money set aside – or other financing options such as leases or loans to spread the cost over a number of years.
  • Be careful not to over-trade. It can sound good when one or more of your customers suddenly increases their normal order, but if you have to add on more overheads, and the customer takes longer to pay, then there can be real cash stress. Even though you are flat out.
  • Reduce your inventory costs. Make sure you order effectively and it’s just what you need. It can be tempting to order in bulk and receive a volume discount, but it does eat into your cash. Sell slow-moving stock and check that your annual rate of stock turn is in line with your industry average.
  • Make it easy for customers to pay you. You could consider ANZ FastPay , an app for your smartphone, that allows customers to pay you as soon as the job’s done. If you invoice, make sure you include your bank account number on the invoice and accept online payment. 

Improve your working capital by shortening the cycle

It’s important to understand the quality of your working capital. You do this by looking at the ‘age’ of your debtors (how long they’ve owed you) and your payment terms with your suppliers.

Here are some key areas to consider:

  • Collect money fast and make sure you have systems in place to deal effectively with people who owe you money, especially before you agree to extend credit in the first place. We’ve got an article on how to make sure you get paid.
  • Is it worthwhile talking to your suppliers about improving their creditor terms for you? Although it seems like a good idea to pay your bills fast, remember that if it’s quicker than your customers are paying you, you’ll need more working capital than necessary. 

Forecast your cash flow

If you can produce accurate cash flow forecasts, you’re going to be in a much better position to see what is happening to your working capital and take steps to improve it before you are forced to.  You’ll be able to predict when you need short-term finance to bridge gaps, and when you’re likely to have an increased revenue stream to invest.

Check your financial health

Use these quick test ratios to assess the current financial health of your business.

Working Capital ratio

The Working Capital ratio indicates the ability of your business to meet its short- term liabilities using current or more liquid assets. To assess your Working Capital (or Current) ratio, divide your Current Assets by your Current Liabilities. If the answer is less than 1:1, you may have a problem and should seek professional help – either your Business Banker or accountant.

Quick Asset or Liquidity ratio

The Quick Asset ratio tests whether your business can meet its short-term liabilities without impacting on the operation of the business. Calculate the ratio by dividing your Quick Assets (assets which can be converted into cash immediately, i.e. debtors) by Total Liabilities (liabilities which may become payable immediately, i.e. an overdraft, creditors). If the result is greater than 1:1, your position is acceptable.

Average Age of Debtors

This ratio measures the effectiveness of your credit control. The shorter the average period it takes you to collect payments, the better. Calculate it by dividing your debtors at the end of a set period by the average daily credit sales. An answer that is less than 60 days is acceptable, but you could set a target of reducing your average debtor days.

Average Rate of Stock Turn

This ratio measures the number of times the stock turns over in your business. It is calculated by dividing the cost of goods sold by the average stock on hand. If this rate is lower than your industry average you have more stock on hand than required.

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