Understanding and Appropriately Managing Working Capital

Working capital management helps you maintain the cash flow needed to meet your short-term operating costs and financial obligations. It considers the money that comes in your door, the money that goes out your door and your inventory. Managing working capital appropriately allows you to:-

• Create reliable and meaningful cash flow forecasts; and
• Ensure you have a clear picture of the transactions you complete and the money sitting in your bank. 

If you don’t manage your working capital, you put yourself at risk of failing to meet your short-term obligations while also failing to remain solvent. Here are 3 key elements to help you better understand your working capital and manage it appropriately.

The Three Elements of Working Capital

There are three elements that comprise working capital:

1. Accounts Receivable:- this is the money you have coming to you from past sales and any debts owed to you. If you fail to collect your receivables, you miss out on the opportunity to pay your creditors, including the ATO and cover your costs. Your accounts receivable is an asset; however, from a commercial perspective, you can’t always think of them as assets until you have the money in your bank account. An important metric used for accounts receivable is known as ‘average debtor days’. This metric measures the average number of days it takes from the time you invoice to the time you collect payment. 

2. Accounts Payable:- this is the amount you owe. In order to maximise cash flow, your goal is to try to keep your accounts payable and accounts receivables in balance. Since you are going to see a notable difference between your accounts receivable and accounts payables, it is important to determine when it is acceptable or necessary to delay payments to offset receivables. However, your goal is to keep your payables as up-to-date as possible to avoid high interest, a poor credit rating and potentially any personal liability for unpaid debt, including taxes and statutory superannuation contributions.

3. Inventory:- how quickly you sell and replenish your inventory is the easiest way to measure your performance. High inventory turnover could indicate a poor use of working capital, meaning you are not converting your stock into sales efficiently. Conversely, low inventory turnover could indicate several things such as:-

1. Excellent sales due to seasonality factors;
2. Poor stock replenishment procedures;
3. Overestimating customer demand for your stock; or
4. Holding onto high-value slow-moving items.

These numbers keep track of how your short-term assets compare to your short-term liabilities.

The Flow of Funds

Working with financial institutions will help you understand how the flow of funds can be used efficiently. Working capital doesn’t always rely on the money in your bank account. You can leverage various aspects of your cash flow to find working capital elsewhere such as:-

• Improve accounts payable cycles:- Sending invoices to your customers/clients in a timely manner. People view invoices as out of sight and out of mind. The longer you take to send your invoices, the longer it will take for you to see the cash in the bank. By delaying your invoicing, you end up staggering your profits which negatively impacts cash flow and ‘locks up’ available working capital. Become more efficient with your accounts payable cycles and free up more cash;
• Do credit checks:- if you offer customer financing,  you might never see that money. When you provide a product or service, your goal should be to receive payment promptly. Offering your own financing might seem like a smart way to attract more clients or make larger sales, but the truth of the matter is, if those clients don’t pay, you are operating at a loss. If you decide you must offer financing, make sure you complete thorough credit checks for every single client before you approve them. You can also reduce credit limits, which means people have to pay more in cash on delivery (COD). This will help mitigate risk for customers who defer payments;
• Be forthright with collections:- ideally, you don’t want to let it get this far. However, if people owe you money, be forthright with collections. Always monitor your past due accounts so you can try to get customers to complete payments owed and generate more working capital. Appointing a debt collection agency can become costly;
• Forecast:- Forecasting helps keep cash flow and spending more transparent. With a forecast, you are more likely to spot trouble areas and adjust to help improve your working capital situation;
• Try to increase average purchases:- explore marketing tactics that can help contribute to an increase in average purchases and revenue. This step is an efficient marketing tool too;
• Keep an eye on inventory:- high inventory levels means your business is less liquid. Try to manage inventory wisely and avoid stockpiling. Your goal is to find the perfect turnover, so your inventory is available to serve customers, but never sitting on shelves collecting dust, tying up capital and potentially becoming obsolete; 
• Plan your accounts payable more strategically:- if you can maintain an excellent credit rating, it will work in your favour. If you encounter cash flow issues, you might find your suppliers more forgiving and willing to negotiate payment terms. Calling on external funding is not always the best way to improve working capital. External funding generally works in situations where your company is healthy and your forecasts have been pretty accurate for the past year or so. However, in a fix, you can also look at how much you can delay accounts payable without risking your credit rating or relationships with suppliers.
• Renegotiate prices:- if you have been dealing with the same vendors for a while, consider better pricing structures. This is easier if you place large orders or have a long-standing relationship with a vendor as they won’t want to risk losing your business. It allows you to leverage your position.

An accountant can help you find more working capital with effective tricks of the trade. This way, you have sound working capital management so you can sleep at night. It also ensures you have some money put aside for a rainy day or for unforeseen events and opportunities that might arise.

Bonitas Partners Pty Ltd makes sure you’re never flying blind when running your business. We are expert working capital strategists who can help you manage your cash flow appropriately.