Working capital is the lifeblood of every business. Yet many business owners aren’t aware of how much working capital they use day to day and don’t plan appropriately for times of seasonal demand or high growth. Here are two simple tools that will clarify this vital metric and help you explain it to your clients.
What is working capital?
In a perfect world, a business would buy stock or provide a service one day and get paid for it the next. With no lag between money out and money in, there would be no need to hold funds within the business to make the next sale or to cover expenses like wages, rent and tax.
In the real world, of course, every business needs a pool of cash on hand to bridge the gap. This pool is the money available to fund a company’s day-to-day operations – known as working capital – and it’s the lifeblood of every business.
Your clients will know from experience how important working capital is, but they may need your help calculating how much they require and accessing extra funds if the need arises.
You can support them by using the following simple accounting formula. But first, organise the numbers into “current assets” and “current liabilities” columns.
Current assets are things the business owns or has a claim on, and that can be rapidly turned into cash – think inventory and accounts receivable.
Current liabilities are obligations that will soon fall due – think short-term debt and accounts payable.
From there, use the formula:
Current Assets – Current Liabilities = Working Capital
If the answer to this sum is positive – that is, the business has more current assets than current liabilities – your client has enough working capital to keep operating, even if conditions tighten up for a while.
But if the answer is negative – that is, the business has more current liabilities than current assets – your client is watching their pool of money drain away.
The textbooks define “current” as “within one year”, but a business can run out of working capital far quicker than that. Every retailer knows the seasonal stress of stocking up on inventory pre-holiday season and waiting anxiously for that stock to turn back into cash.
A growth opportunity can impose the same pressure. Gearing up to fill first-time orders requires new investment, and this usually means seeking funding.
Prospa tip: The amount of working capital a business needs varies across the year, so drill down to quarterly or even monthly figures to see the true picture.
More time needs more money
Another way to get insight into working capital is to calculate how many days it takes, on average, for the money that goes out to come back in. This is known as the “operating cycle” or “cash-conversion cycle”.
To calculate a client’s cash-conversion cycle, you need three numbers:
- Inventory days: How long stock sits on the shelf, or how long the business has to pay for labour and materials to create a saleable product.
- Debtor days: How long it takes to collect payment from customers.
- Creditor days: How long the business can hold on to cash before it must pay suppliers.
Here’s the formula:
(Inventory Days + Debtor Days) – Creditor Days = Cash-conversion Cycle
Inventory Days (55) + Debtor Days (45) – Creditor Days (30) = 70 days
This client waits 70 days for their outlays to turn back into cash. The cycle can blow out if, for example, sales suddenly slow down. A smart manager can shorten it too by speeding up collections or extending trade terms with suppliers.
Once you have calculated a client’s cash-conversion cycle, you can help them shorten the period they are out of pocket and plan their finance needs.
Prospa tip: The typical cash-conversion cycle differs from one industry to another, so look for patterns and identify what the most successful businesses in each sector are doing right.
Sources of working capital
Most business owners launch their enterprise by investing their own money. If things go well, retained profits will gradually increase the funds the business has at its disposal.
If the business needs more capital, the owner may come to you looking for finance. But the traditional option – a bank loan – has drawbacks. The borrower may need to put up their home as security and is then at the mercy of interest-rate movements.
A useful alternative is cash flow lending. With cash flow lending, the health of the business is used to assess loan applications. Repayments are often structured to suit the business and work with the business’s cash flow (usually daily or weekly). The total amount to be repaid is outlined up front, and with lenders like Prospa there are no penalties if you pay out early.
Prospa tip: Look for a cash flow lender that uses a “factor rate” to protect your clients from interest-rate fluctuations.
Zero in on working capital
If you understand your clients’ working capital requirements, you can help them shorten their cash-conversion cycle and plan for times of business stress. Providing the right type of finance at the right time can keep your clients afloat and build your own business as well. Discover how partnering with Prospa can benefit your business by calling us today on 1300 964 808 or emailing [email protected].
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