To talk of financial management and not touch upon working capital management is not possible. This GroFin business support guide provides an overview on working capital management to help entrepreneurs understand the importance of working capital for building a sound financial future for the organisation.
The Basics of Working Capital Management
Simply stated, working capital management is the process of managing activities and operations related to working capital. To break it down into its constituent elements, the management of working capital involves managing inventory, accounts receivable, accounts payable, and cash.
The goal of working capital management is to place the company on a firm footing to continue its operations and enable it to meet both short-term obligations and operating expenses as and when they fall due.
Elements of Working Capital
Working capital consists of four elements – cash, creditors, inventory and debtors. We shall consider each element of working capital one by one to help us understand the importance working capital management.
Cash management is a critical element of working capital, as all the other parts of working capital are geared towards ensuring the quick turnaround of cash in your business. How quickly you covert debtors and stock to cash can be an important index of the liquidity of your business, and reflect its ability to meet current obligations such as accounts payables, wages, dividend and taxes.
Ultimately, cash is king. Sales are important, yes, but making sure that you get paid in time for what you are selling is equally, if not more, important. To highlight the importance of cash to a growing business, many entrepreneurs have told us that while their sales increased year-on-year, they still lacked funds to cover their overhead costs. Ultimately, inadequate credit and collections policy were found by our team to be the underlying cause.
Inventory management is critical, particularly for the stock intensive manufacturing, wholesale or retail space, where inability to convert inventory to debtors, and debtors to cash in a time-bound manner, can cause your business to have idle or slow-moving stock. This in turn, will cause your business to undertake needless expenses to store such stock, take care of it, and at the worst, dispose of it at a loss.
We must reiterate that inventory/stock purchases are an important part of the cash cycle or “operating cycle” of any business. First, the company makes payments to suppliers and then receives the stock (supplier days or payable days). Next, the stock is processed –depending on whether it is finished/ready to sell stock or raw materials that will be part of the production cycle – so the processing time should also be factored into the operating cycle.
Finally, a critical component of the operating cycle of a business are the sales terms, whether on cash or credit terms. Hence, the nature of the inventory, order amount, payment terms, time of receiving the stock, and processing time should be evaluated against sales and collection of monies from customers (receivable days) so that you can accurately assess your operating cycle and your business does not face cash shortages.
Accounts Receivable Management
Managing your debtors is an essential element of working capital management, as sales made must be evaluated against the timely receipt of monies from your clients. Bottom-line: Until you get paid by your client, the sale is not closed.
Indeed, we often hear clients saying that sales are up but they encounter cash flow problems as a result of the very sales that they have made – on credit terms. Customers pay late, or, in some cases, not at all, effectively ensuring that the money has not yet been received against sales made but cash has already been paid by the entrepreneur to buy the goods meant for sale.
In effect, collecting money from customers can be one of the toughest tasks that your business faces, especially when it is an entrepreneurial venture where timely receipt of monies from your clients can mean the difference between paying your staff their salaries, and telling them to wait yet another month till pay day. In the worst case, delayed payments from your customers could force you to re-negotiate and stretch payments to your own suppliers, causing your creditworthiness to take a nosedive.
Accounts Payable Management
Accounts payable management or creditor management is an important part of working capital management, and, of all your creditors, suppliers are easily the most critical category.
Thus, managing payments to your suppliers could easily be the biggest worry you face while running your growing business, especially if the supplier has more bargaining power than you do. And, higher bargaining power on the part of your suppliers is an eminently possible scenario when yours is a small business that is just beginning to spread its wings, while your suppliers are established business houses that have been dealing with the cut-throat corporate world for many years.
Another important aspect of account payables management is to manage your relationship with your suppliers in an optimal manner. Considering that stock is the life blood of any business, any path that causes your relationship with your suppliers to take a hit is clearly not to be pursued.
Working Capital Management – In Practice
As a GroFin client, your GroFin Investment Manager can assist you in evaluating your current working capital management systems and help you put in place more efficient systems that work for your start-up or SME. Contact your local GroFin office to learn more.