The importance of working capital is often overlooked by businesses, both large and small. But getting the level of your working capital right is an important part of running a successful business and it can be the difference between going bust and growing big.
What is working capital?
In its simplest form, working capital is the net working capital you need to operate your business – basically the value of all the money you have tied up in the workings of the business.
For a business that makes or sells products, working capital is right there on the shelves of your warehouse, factory or shop. It’s even in the raw materials or parts you’re going to make things out of, and the goods you’ve made or bought, but have yet to sell.
The other big contributor to working capital is money you’re owed. If you offer credit to clients, that’s for work you’ve done or products you’ve sold – but the money is not yet in your bank account. This is also cash that’s tied up in the workings of the business.
Conversely, getting credit from your suppliers is ‘negative working capital’. When you hear people talk about Amazon’s amazing ability to generate cash flow, it’s negative working capital that they’re talking about. Amazon gets generous credit terms from suppliers. And it collects cash from consumers immediately on sale. So it has negative working capital – the more stuff it sells, the more cash it frees up.
Supermarkets and some other businesses (insurance companies, for example) also fall into this happy category. But unfortunately, most small business owners reading this don’t. The more business you do, the more raw materials or stock you need; the more credit you need to give customers and clients; and the more reliant you are on your suppliers.
That means you require extra working capital to keep your business moving forward and growing.
Here are six great reasons to pay more attention to the detail of your working capital – and work out whether it’s in the right shape for you.
1. Creating capacity to grow
The overdraft facility has been a well-tested method of covering short term cash demands. However, this was also one of the reasons businesses became upset when banks started to cut back on overdraft facilities after the global financial crisis. This highlighted how the need for quick access to extra funds is essential if you suddenly win new business or need to fulfil extra orders to satisfy clients. Having ‘working capital headroom’ – funds available over and above what you currently need to meet orders – is crucial for growth.
2. Avoiding overtrading during an upturn
A lot of people think the idea of ‘overtrading’ can never be a bad thing. How can your business be too successful? But tie up too much cash in stock and credit and suddenly you may be struggling to pay your bills, but this is a trap that can easily be avoided. As the economy gets going after Covid-19, having a detailed idea of your working capital – how it might change over time, and where you might need to cover any gaps – will be essential to avoid getting into trouble.
3. Having better controls over credit
You never want to offer credit to ‘dodgy’ customers. But we’ve all been in situations where a blue-chip client, or customer you know well, expects generous payment terms – and in many cases, corporates get assumptive, expecting 60 or even 90-day credit. Understanding exactly how that affects your working capital going forward – and what it’s costing you in terms of lost orders elsewhere, or additional financing – helps you decide when to offer credit, what terms to accept and how you might price products and services as a result.
4. Streamlining processes
Expensive cashflow consultants get their quickest wins – and most client satisfaction – by tackling low-hanging fruit. Lax credit control and poor systems for chasing money, or timing payments out, consume the working capital of a business. Analysing and monitoring its components (consultants talk about days of sales outstanding, days payables outstanding, and days sales of inventory – DSO, DPO and DSI) can point to where better systems, carefully applied processes or a good credit controller can help.
5. Reducing the cost of borrowing
When you’re on top of working capital, you can plan your financial needs much more efficiently. No business leader wants to set up an expensive term loan or sell off equity in their business (a very expensive form of financing!) on the off chance their working capital needs will rise. Monitoring and forecasting cashflow, and predicting your working capital needs, mean that you can seek out the right finance only when you need it – whether it’s short term to cover a big one-off order or something ongoing to support a step-change in growth.
6. Terms and conditions
By planning ahead and understanding the cash flow of your business you can understand when the “pinch points” are coming in your working capital needs. This will then give you time to obtain the right finance for your business on good terms. We all know the feeling of leaving it to the last minute and having to accept a deal with no real negotiation when we have a deadline to meet!
If you need help with your cash flow, have exciting and ambitious growth plans, or want to maintain your existing success, we’re here to offer a hand.
We recently launched a new £50m Small Business Fund to support business owners that require additional finance and you can check your eligibility in just 60 seconds. Take a look at our online form here with no commitment and no impact on your credit score.