Managing working capital effectively is an important business discipline, regardless of the stage of business’ life-cycle you have reached. Within a start-up or growth phase, many businesses grow rapidly, go out of cash and fail. They only do not keep pace with the business enterprise increasing cash needs. Established businesses must pay close focus on cash flow and maintain adequate working capital to pay suppliers and expenses.
Within my experience, business owners often overlook two essential questions when addressing their working capital needs. Firstly, how much they require and secondly, how they’ll finance or fund it. Determining your business’ “cash conversion cycle” is often an excellent indicator of your working capital needs. It’s determined by calculating how fast your organization converts its purchases (materials, inventory, etc) into cash received from customer sales.
Managing Working Capital Effectively
You need to use other working capital ratios or measures to review working capital needs. Ratios such as inventory turnover, creditor days, and debtor days may be used to greatly help identify potential concerns or trends. Regularly reviewing them can help you prevent inadequate liquidity and cash flow and enable one to take proactive action before it’s too late.
Adopting “better business practice” will allow you to manage cash receipts from debtors (also called “accounts receivables”). Providing easy payment methods, developing and sticking with credit policies, and following through to late payments will all help. However, you will need to consider any possible negative effect these could have in your customers. For example, customers may go elsewhere if your credit terms are unfavourable to them.
Paying close awareness to paying your suppliers and expenses (“accounts payables”) is equally as important. Pay invoices when they are due (rather than paying early); check invoices for accuracy, negotiate credit terms, and utilizing any prompt payment discounts will all help. Understand that in doing this you will need to make sure that your suppliers continue to produce you with materials, utilities, etc.
Economic Order Quantity
For many business, a significant area of good working capital management is in managing inventory. Determining optimum stock levels and the perfect time and energy to re-order inventory may help preserve cash. The “Economic Order Quantity” (EOQ) calculation can help you to determine just how much inventory you need. It will help you to balance “holding costs” (warehousing space, etc) with costs related to ordering stock (“delivery charges, etc). EOQ may also help stop you running out of inventory by determining “safety levels “.
Irrespective of whether your company is just a start-up or not, managing working capital effectively is going to be crucial to your success.