Put Your Working Capital To Work
If you are a small business owner in search of capital, you know the process can be challenging. Bank loan applications are onerous and time-consuming. Equity infusions can be complex and require long lead times to accomplish. Before you head down this path, be sure to explore one source of capital that’s often overlooked.
Working capital is a financial metric that measures the amount of capital held internally to fund operations. Net working capital (current assets minus current liabilities) is used to predict a company’s ability to cover short-term obligations. But this simple calculation is just the tip of the working capital iceberg. Business owners that fully understand the elements of working capital, and manage those elements effectively, can unlock a significant source of funding inside their business.
Sound working capital management requires an understanding of the cash conversion cycle, which measures how long it takes to recover the cash you invest in operating resources. Consider a manufacturing company that purchases raw materials for production. How long will it take the company to recover that cash? Think about all of the phases in the cycle, and how each impacts working capital.
- Credit terms – how soon is your payment due after inventory is shipped or received? Can you negotiate more favorable terms?
- Raw materials inventory – how long are raw materials in inventory before they enter the production cycle?What are the storage and handling costs of the inventory?
- Production – how long does the production process take?Are spoilage and/or defects kept to reasonable levels?
- Finished goods inventory – how long do finished goods remain in inventory before they are shipped to a customer?
- Shipping – when are goods considered to be delivered to the customer, when they are shipped from your warehouse, or when they are received by the customer?
- Billing – how long does it take to issue an invoice after delivery of an order? What are standard payment terms?
- Accounts receivable – what percentage of customers pay on time? What are the procedures to collect past-due accounts?
- Customer receipts – where are customer checks received?How long does it take to process cash receipts and post payments?
- Depositing funds – How long does it take to deposit customer funds in to an operating account?
Good managers of working capital know exactly how many days are spent in each of the phases above, and work to reduce those numbers in every reasonable way.
Some elements of working capital, like inventory and accounts receivable, can also be used as their own sources of financing. Vendor financing programs may allow you to pay for inventory purchases over an extended period of time. And if your receivable balances are stable and predictable, you may be able to borrow against them under a factoring or receivable financing program. These arrangements are often less onerous than bank or equity financing, but consider the terms carefully and compare the costs to your existing financing costs.
Of course, there are limits to how much you can squeeze out of working capital. Additional liquidity is important, but so are your vendor and customer relationships. The art is in finding the appropriate balance. And good working capital management does not have to wait for a specific capital need. Start optimizing your working capital today, and not only will you see immediate benefits, but you’ll be in a stronger position when it comes time to talk to those lenders or investors.