It is only too true that expenses tend to outstrip income at the start of a business venture and only too few, if any, new businesses are profitable as soon as they are launched. It takes time for a business venture to reach its break-even point and to start making a profit. Hence, keeping a tight control on working capital is essential for entrepreneurs who are focused on a long-term horizon, as a sustainable business can only be built on efficient working capital management systems.
Before diving deeper into the vast domain of working capital management, it is important to define precisely what constitutes working capital. To put it simply, working capital refers to the funds needed to carry out your recurring and routine business operations. It allows you to meet your short-term debts and operational expenses as they fall due, which can be particularly important for start-ups and growing businesses.
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 inventories, accounts receivables, accounts payables, and cash.
The goal of working capital management is then 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.
1. Working Capital Cycle
A good metric to evaluate the efficiency of working capital management is the duration of the working capital cycle. A working capital cycle measures the time taken from receipt of raw materials from supplier to realisation of cash from debtors. It is in the interests of the organisation to keep its working capital cycle as short as possible to ensure that cash is received into the business with minimum delays, and can be used to fund the next sales opportunity. The shorter the turnaround time for a transaction from purchase to receipt, the more the number of sales opportunities that can be met in a given period.
A typical working capital cycle consists of the following elements:
- Cash (funds on hand)
- Creditors (accounts payable)
- Inventory (stocks on hand); and
- Debtors (accounts receivable)
One or more elements of the working capital cycle may find their relative importance lower or higher, depending on the industry type and the stage of maturity of the business. For instance, a services organisation will not have a marked inventory element, other than petty items such as stationery and tools for office use. Hence, inventory management will not be an important element for such an organisation. Similarly, a start-up may not have too many product lines it is dealing with, hence the scope of inventory management may be limited. As the business expands and diversifies into different product lines though, it may find itself using more complex inventory management systems and inventory, as a part of working capital, may find itself gaining increased importance in the business as it matures.
2. Working capital formula
As a rule of thumb, you can measure the working capital in your business in terms of the difference between the current assets and current liabilities of your business. Refer to your latest balance sheet to correctly assess the level of working capital in your business.
Remember, current assets are items that are either cash, a cash equivalent, or can be converted to cash within the year. Current Assets cover cash, accounts receivables, stock, pre-paid expenses and short term securities. On the other hand, current liabilities are debts or obligations that are due within the year. Current liabilities cover accounts payables, wages, dividend and taxes.
However, while the working capital formula allows you to arrive at the exact figure of working capital held in your business, it does not allow you to gauge the safety margin that your current level of working capital offers. In other words, do you need more working capital to stave off the creditors, or can your business make do with less working capital and invest idle funds in interest-yielding avenues? To arrive at the margin of safety, you must calculate the ratio of current assets to current liability and evaluate the liquidity position of your business.
3. Working capital ratio
The working capital ratio (more commonly referred to as the current ratio) refers to the relative proportion of current assets to current liabilities, and shows the ability of the business to meet its current liabilities with the use of its current assets.
A ratio above 1 means current assets exceed liabilities, and the higher the ratio, the better the safety margin it affords the business on a liquidity front. A low ratio would imply that a business might fall short of meeting its current obligations with the current resources at its disposal, putting it at risk of payment default.
However, a ratio that is too high could also mean that the business is not efficiently using its current assets or short term financing facilities. Indeed, depending on how its components are allocated, a high current ratio may suggest that that company is not using its current assets efficiently, is not securing financing well or is not managing its working capital well. In such a situation, a quick ratio (also called an acid test ratio) may be a better indicator of the short-term liquidity of the business. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. It excludes inventories from current assets to arrive at a more accurate measure of the ability of the business to meet its current liabilities with its most liquid assets – cash, debtors and short-term securities.
4. Elements of Working Capital
As is clear by now, working capital consists of four elements – cash, inventory, debtors and creditors.
Refer to our individual guides on each of the elements of working capital, to arrive at an in-depth understanding of working capital management in totality:
5. How can GroFin help you?
With its unique value proposition of finance and business support, GroFin not only provides you with finance to meet your working capital needs, but also equips your business with the working capital management systems to make it sustainable over the long term.
Take the case of BOP Investment Ltd, a trade representative for Nestle, Olam and Stallion products in Ghana, where GroFin helped entrepreneur Benjamin Anim take advantage of new opportunities by better managing his core working capital.
With 14 years’ experience and industry knowledge, Benjamin has shown that determination is the key to succeed. Starting with a small capital base, over the years Benjamin grew the business at a slow and steady pace and ensured that he put most of the profits back into BOP for use as working capital.
“With little resources, I embarked on this unfolding life changing course,” explains Benjamin.
Today, BOP has two sales outlets, one in Asamankese in the Eastern Region and the other one in Accra. It uses numerous distribution fleets to serve bulk buyers and its main distribution channels include retail outlets such as grocery shops, kiosks, open market stalls and table tops.
In 2015, Benjamin signed contracts for BOP to be a local distributor for other global brands such as Cadbury, Primex, Voltic, Promasido, and Mansell.
It was then that the need for better working capital management systems to meet growth opportunities motivated Benjamin to seek GroFin investment and support.
“This is a flourishing volume driven business with stable cash flow, however profit margin is generally low,” explains GroFin Investment Executive, Samuel Sedegah. “With suppliers’ price inflation further reducing cover for inventory, BOP needed our finance and support to sustain and increase its inventory levels.”
As much of BOP’s merchandise is everyday consumables, GroFin expects the business to prove resilient by returning positive cash flow.
“Besides helping BOP with working capital finance and management, we helped Benjamin leverage on his established distribution network to grow BOP’s product portfolio, as well as its customer network,” adds Samuel.
“Now, with GroFin support, the business is ready to take advantage of new opportunities,” concludes Benjamin.
Throughout our relationship with you, from the pre-finance stage to the post-finance stage, GroFin will provide your business with appropriate business support designed to meet its growth needs. To date, over 8,000 entrepreneurs have benefited from our business support expertise. You could be one of them!
Apply today and get the GroFin advantage on your side.
This post was originally published on LinkedIn Pulse by Nishika Bajaj.