For driving your business growth, relying just on your passion and basic instinct is not enough. You require a whole lot of other skills to survive and flourish. While there are numerous important aspects which need to be taken care but, in our opinion, one of the most crucial aspects is recognizing the need and possessing the ability to understand key financial aspects. These conclusions would undoubtedly benefit your business. As a business owner you need to consider the impact of the management decisions on the profits, cash flow and on the overall financial health of the company.
Before we talk about these crucial financial aspects further, let’s have a look at some key terms that you need to know:
Accounts Receivable
Accounts receivable (AR) is the balance of money due to a firm for goods or services delivered but not yet paid for by customers. Accounts receivables are listed on the balance sheet as a current asset. AR is any amount of money owed by customers for purchases made on credit.
Accounts Payable
Accounts payable (AP) represents a company’s obligation to pay off a short-term debt to its creditors or suppliers.
Working Capital
Working capital is an indicator of the short-term financial position of an organization. It is also a measure of its overall efficiency. Working capital is obtained by subtracting the current liabilities from the current assets. This ratio indicates whether the company possesses sufficient assets to cover its short-term debt or not.
Working capital = Current Assets- Current Liabilities
Credit period
The credit period is the number of days allowed to a customer for payment of invoice. This concept is of utmost importance because it indicates the amount of working capital that a business is willing to invest in its accounts receivable in order to maximize sales.
Start planning your finances right at the beginning
Businesses experience losses and negative cash flow during their startup period. This makes financial management extremely important during this period of time. The management needs to ensure that the business has enough cash on hand to pay its stakeholders like the employees and the suppliers. Even if there is more money going out than coming in during the early days of the startup phase. As an owner, you must make financial projections of these negative cash flow so that you have a fair idea on how much capital will be needed to fund the business until it becomes profitable. In our opinion, the primary goal of the financial management is to :-
- Source the funds at the lowest possible cost,
- Control the Company’s cost of capital and
- Not letting the balance sheet become too highly leveraged with Debt with an adverse effect of its credit rating.
Optimization of your working capital
Working capital serves as blood circulation in any enterprise and its optimization can help your business become much more efficient and competitive. Thereby allowing for a consistent growth. Return on working capital acts as an excellent indicator to determine if the company’s capital is deployed with the right customers and in the right type of inventory.
While your books of accounts might reflect the revenue being generated with a very fast turnaround of the inventory, it doesn’t necessarily mean that you have positive cash flow in the system. A lot of your capital might be stuck with a few debtors who have longer payment periods despite buying ample inventory from your business. You can easily verify it from the account receivables report generated by your accounting software.
While there are many other ways to strengthen the working capital of the business, here are the 3 key areas of Working Capital along with a few measures to improve their efficiency.
Account Receivables
It is really important to understand the payment performance of your debtors to efficiently manage your working capital. Your business must allow the credit period to the debtors (buyer of goods) based on a carefully drafted credit management policy. The key function of the credit management team should be to optimize the sales at the minimum possible cost of credit.
Here are some of the most common determining factors to decide upon the credit period to be allowed to the buyers:-
- Payment history (A debtor who is a good pay master may be allowed a longer credit term as opposed to a debtor who is a habitual defaulter and not paying the invoices on time)
- Substantial impact of the debtor on your cash inflow ( A customer may be contributing a great portion of your sales. And a single payment default by him may delay the payments to your vendors and employees causing a major cash crunch for an uncertain period)
- Credit Score with credit rating agencies ( Information on commercial credits as well as reports on businesses maintained by external agencies can act as a major yardstick to determine the credit period)
There are several other factors which might be critical to determine the suitable policy but we will stick to the most common ones for now. The faster you convert your receivables into cash, the higher is the cash availability for your business. Timely and efficient management and collection of accounts receivables is the key for positive working capital impact.
Account Payable
It is important to treat payables at par with the receivables as it helps the business in becoming more efficient. Account payable is the short-term debt which the company is obligated to pay and is one of the key cash outflows.
Here are some of our tips for ensuring a sturdy positive working capital:-
- Taking full advantage of the credit period and delaying the payment as far as possible within the credit terms allowed by your vendor. This will help you to balance the cash outflow and inflow.
- Preferring vendors who offer flexible payment terms and discounts on earlier payment will help here. ( A vendor allowing a 2% discount on paying the invoice within 2 weeks is pretty typical)
- Ensuring average time to collect receivables should be significantly shorter than its average time to settle payables. This helps in meeting working capital needs of the business. This definitely requires better cash flow projections but, in turn strengthens the relationship, reputation and better negotiating position for the future.
Efficient inventory management
The other important aspect impacting the working capital is management of inventories. Business practices in small & medium sized enterprises are so diversified that in most cases, the decisions are based on elements like schemes, better price deals or just relationships. Most of the time these decisions are not in line with the business needs. These ad-hoc decisions lead to either overstocking or a situation of dead inventory. In our opinion, the inventory carrying cost can be optimized by adopting a slightly better approach and practices like
- Efficient re-ordering cycles considering reorder levels,
- Lead time,
- Consumption/sales patterns and
- Minimum quantity of supply etc.
These will not only free up your blocked capital but will also prevent situations like dead/outdated/ slow-moving /high-cost inventory in stock thereby preventing losses due to unmanaged purchase practices. Managing sufficient stock to meet the forecasted demand will help to mitigate the risk of cash blockage and ensure the right investment of money into inventories.
A stronger working capital ensures availability of sufficient cash cushion or cash flow to seed future growth and expansion plans as well as servicing short term debts whereas the Negative working Capital reflects the financial difficulties of the business and may lead to closure of the business in case the trend continues for a longer time. Proper understanding and optimization of working capital can have a significant impact on the entire business and helps to align the business strategy with the ongoing operations in a much better way. Plus, a good understanding of your working capital would definitely help you in improving the overall efficiency and productivity of your business.