Understanding and improving working capital
Working capital is the cash you have each month to cover any expenses. If your overheads are $100,000 a month, and you want 3 months in advance at all times, then your working capital requirement is $300,000.
The essential point about working capital is that it’s the cash required for the day-to-day running of operations.
Generally, the longer the business cycle the more working capital you require. A business cycle is the time taken for a product to be made (or bought in) then on-sold, money received and cleared at the bank. For a hairdresser, this could be few weeks, from when the customer books the appointment to leaving and paying on the way out.
Improving working capital
One of the first things to do is decide how much working capital you’ll need. Use a cash flow forecast to calculate when you may run out of cash, and what base level of capital will help prevent that occurring.
Reduce working capital needs
The more you can cut down on expenses, the better. In order to manage your working capital effectively, consider the following:
- Cut down on large personal withdrawals. If you have spare cash, make sure your business doesn’t 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.
- Avoid overtrading. 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.
- 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.
- Make it easy for customers to pay you, especially by providing mobile and online options.
Shorten your cash cycles
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.
It's worthwhile talking to your suppliers about improving their terms 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.
Conduct cash flow and profit-and-loss forecasts
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.
Profit and loss forecasts are designed to help you assess the future profitability of your business, so you can make better, clearer decisions about your working capital needs.
Ideally, you’re aiming to reduce any working capital jitters you might have by fully understanding what working capital is, how much your business needs, and ways you can continually improve on it. Once you’ve learned how to effectively manage it and have put these simple processes in place, it’ll become second nature to you, so that you can then focus on growing the business and increasing profitability.
Consult with your accountant about your working capital needs, how you can reduce them, and what you can do to improve them.
Consider updating your payment options so that customers can pay you faster, keeping more cash in your business.