One of the most important financial aspects of operating a business is properly managing cash flow and working capital. A healthy flow of working capital will contribute significantly to the success of the business.
The Working Capital Cycle
Working capital consists of the net difference between current assets and current liabilities, which flow in a ongoing cycle in a business. Assets and liabilities are generally considered to be short-term, or current if they are reasonably expected to be turned over within the normal course of the business cycle. This cycle starts with cash invested in the business, or obtained through financing. This financing may be in the form of bank loans or lines of credit, or may consist of purchases on credit from vendors and suppliers. Bank loans or lines of credit generate short term liabilities. The portion of loans due within a normal business cycle, or for accounting purposes generally considered to be one year, are classified as current liabilities. And trade accounts payable to vendors normally have payment terms of 30, 60 or 90 days, for example, also resulting in short-term liabilities.
The cash contributed to the business or borrowed, or the credit obtained from vendors is used to either purchase merchandise for sale, or to purchase raw materials and supplies for producing inventory, which is also an element of working capital. The cash is also used to pay salaries and wages, rent, utilities, and other operating expenses, and in a production environment, to pay the overhead costs involved in production.
Inventory is then sold to customers either on a cash basis or on credit. For cash sales, the revenue replenishes the cash balance, with a profit margin, and the cycle begins again. If sales are made on credit, they generate trade accounts receivable – also an element of working capital. Collections on these accounts receivable subsequently generate cash and the cycle is again complete.
If the business involves providing services rather than selling inventory, the cash at the beginning of the cycle is used to pay operating expenses and the costs of providing the services. Payment for the services is either collected upon completion, or is billed to the client, setting up an account receivable. Many businesses offer both products and services, and in this case there would also be inventories included in working capital.
Provided the business is generating profits, the end result of the working capital cycle will be additional cash. This cash can then be reinvested in the business to generate additional profits and to grow and expand. The additional cash could also be kept as a reserve, or could be withdrawn from the business. Generally, the cash will probably be used in a combination of these ways.
Amount of Working Capital
Working capital is essential to the operation of any business, and having an adequate amount of working capital available is crucial to the success of the business. When working capital is too low, the liquidity of the business, and the ability to meet its short-term commitments, and payments on long-term liabilities is jeopardized. And too much working capital may mean that assets are not being efficiently used to their full potential and benefit.
As mentioned above, working capital is defined as current assets minus current liabilities. Current assets include cash on hand; amounts held in bank accounts; marketable securities; accounts receivable from customers, clients, and other parties; inventories; and prepaid expenses. These are all assets that are generally turned over during the normal business cycle. Current liabilities include short-term bank loans payable; lines of credit; accounts payable to vendors, suppliers, contractors, and other providers of materials and supplies or services; accrued expenses; taxes payable; and the current portion of long-term debt – the installments that are due within one year.
Provided current assets exceed current liabilities, the business has positive working capital. If current liabilities exceed current assets, working capital is negative, resulting in a potential liquidity problem. There will not be enough current assets to be converted to cash during the normal business cycle to meet the obligations falling due within that period.
But, just having a positive balance in working capital may not be sufficient. The actual amount of working capital on hand should be compared with the amount of working capital needed. If working capital on hand is less than what is required, there is a deficit in working capital. On the other hand, if working capital on hand is greater than what is needed, there is a surplus of working capital.
For a business just starting up, the estimated working capital that is needed should form part of the financial analysis and projections done in preparing a business plan, strategy, and budget. For an ongoing business, working capital requirements may be based on experience, in addition to taking into account the plan, strategy and budget.
An aspect to keep in mind in determining working capital requirements, for both a start-up business, and an ongoing business, is to have sufficient working capital to be able to confront unforeseen difficulties, and to take advantage of opportunities that arise, such as cash discounts on early payments to suppliers, thereby lowering the cost of goods sold and expenses. Also, working capital may be needed to expand sales, finance the development of new products or services, to replace machinery, equipment and other fixed assets as they wear out or become obsolete, to finance advertising or marketing campaigns, and to do research and development.
Working Capital Deficit
When there is a working capital deficit, some of the following measures, or a combination of them, may need to be taken:
· Attempt to have your suppliers store your raw materials and supplies, thereby reducing the amount of cash you have tied up in inventory, and the expenses that result from having to maintain inventory on site.
· Reduce the number of days in the production cycle, that is, the days from the first receipt of raw materials through the completion of the final product. This may mean better planning and scheduling of orders for materials, better use of available resources and manpower, and looking for efficiencies that can be gained in the production process.
· Sell scrap materials and obsolete inventory items that are taking up space and generating additional inventory maintenance expense.
· Bill customers and clients earlier. Coordinate the shipping and billing processes. Incorporate the use of any information systems that will facilitate the billing process.
· Speed up collections from customers and clients. Maintain a close follow-up process on outstanding accounts, send statements, and make collection calls regularly.
· Pay invoices when they are due, and not before, unless you can take advantage of cash discounts for prompt payment.
· If possible, negotiate longer payment terms with vendors and suppliers.
· Increase owner’s equity or long-term financing, in order to decrease the use of short-term debt to finance operations.
· Refinance long-term debt at more favorable rates, in order to reduce current installments (and also reduce the total interest cost of the debt).
· Sell off fixed assets, preferably those that are worn-out, obsolete, or that are not serving to generate income.
Working Capital Surplus
When there is a working capital surplus, it may be advisable to take some of the following measures:
· Maximize the use of cash. Invest idle cash in marketable securities in order to earn a return, or take advantage of purchase discounts for prompt payment.
· Use surplus cash to pay down long-term debt and thereby reduce the interest cost over the life of a loan.
· Make capital expenditures, such as purchases of property, plant and equipment, that will increase your business’s productivity and profitability.
· Use surplus working capital to help the business grow and expand. Expenditures may be needed to increase market share or to develop and promote new products and services. And investments, such as in research and development, can be made that will benefit the business in the future.