Working capital: The basics

Working capital is the lifeblood of any business. But what is it, and why is it so vital?

Simply defined, working capital represents the amount of money in the business that is tied up with customers and owed to suppliers and HMRC, as well as stock or work in progress. For many businesses, it follows a cycle, but it may also be highly seasonal.

Rob Rattray is a former corporate finance adviser who now works with SMEs, helping them design financing structures that allow them to grow while maintaining control over their working capital and cash management.

He says there are some important questions that businesses must answer in order to get a strong grip on good working capital management.

See also: Finance jargon buster guide for SMEs

How does managing working capital impact the cash the business has available?

Most businesses fail due to lack of cash. This can include even the biggest and most high-profile businesses in the UK. “Cash is needed to meet the day-to-day needs of the business,” says Rob. “If you’re unable to pay debts as they fall due, you’re technically insolvent [this is the cash-flow definition of insolvency; the other definition is when it has more liabilities than assets on its balance sheet – the balance-sheet test].

“If your customers delay paying you, you’ll have less cash in the business. If your suppliers require you to make payments upfront, or shorten the term of your credit, then again you will have less cash in the business. If you over-order stock for the business and fail to sell it, you’ll have less cash in the business.”

How does cash flow and the cash cycle affect working capital?

The cash cycle is an important concept because it describes the flow of cash out of the business and back into it again as a result of trading. “Critically, it doesn’t happen at the same time as sales or cost of sales,” Rob explains. “Cash goes out to pay for suppliers, wages and salaries and other expenses [some of which are on credit], and cash then comes into the business in the form of sales, which also might be subject to credit.”

Rob adds, “It’s also important to understand that working capital generates the swings in cash on the balance sheet and impacts your ability to pay bills at the end of the month or cycle.

“Two notable ratios include the current ratio and the quick ratio. This equates to current assets/current liabilities for the former, and current assets less inventory/current liabilities for the latter.”

See also: What’s the importance of a cash flow forecast?

Both of these ratios are used to test a company’s liquidity, length of cash cycle and investment in working capital, providing an insight into whether the business has sufficient current assets to cover its current, or short-term, liabilities.

So, if a business has £400,000 in assets on the balance sheet, with liabilities of £200,000, then its working-capital turnover ratio is 2:1. A ratio lower than 1:1 indicates the business may soon have difficulties with cash; if it’s nearer 2:1 then the company is managing its working capital well.

“While both ratios should be over 1, the absolute figures are not as important as tracking changes to the ratio (and be aware that some industries vary significantly).”

What skills does good working-capital management require?

Rob says keeping on top of working capital requires a range of skills – financial, operational and service-oriented. “It’s as much about your relationship with your customers and suppliers as it is about your financial and operational skills.

“You must be on top of your reports [stock, debtor and creditor management, including the rolling 13-week cash-flow forecast], so you understand the working-capital picture [this includes the relevant ratios and KPIs].

“You also need accurate systems that ensure stock is counted, invoices are accurately issued and verified with customers, and supplier bills placed on the system or accrued for.”

See also: Six accounting hacks for SMEs and start-ups

Common working capital mistakes to avoid:

• Failure to put in good working-capital management processes
• Holding on to old stock
• Delaying taking action to rectify an imminent cash squeeze
• A failure to recognise the signs that your business lacks sufficient working capital given the scale of the business. You can address this by injecting a longer-term source of funding such as equity or debt
• Trying to grow too quickly given the amount of funding in the business

Working capital quick wins worth considering:

1. Always invoice on time, chasing up outstanding debts with an escalating level of steps, negotiating payments from customers with long-term projects, re-negotiating favourable terms from suppliers, and reducing unnecessary overheads
2. Make sure to check the initial invoice is sent complete/correct, as early as possible and tactically at the right time and takes into account the type of company and its particular payment cycle
3. Consider issuing pro-forma invoices on some customers to gain payment in advance of dispatch
4. Sell more via your website or pop-up shop to help turn stock into cash – typically at a higher margin than via B2B or wholesale
5. Use credit software before taking on a new customer to check the strength of the business before offering credit terms
6. Liquidate old stock regularly – keep it churning
7. Ensure that the terms and conditions of the contract are clear. For instance, check that customers do not retain title of the goods you send them until the goods are paid for
8. Get ahead of the game by taking a proactive approach to collecting cash. Ensure that communications are personal – and that means phone calls rather than just emails

This article first appeared on NatWest Business Hub

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