I have set up (and 5 years later sold) a technology company and managed the commercial aspects of several businesses. As I wrote in a previous blog that most business people accept that “cash is king”, without realising that tight management of working capital is the foundation on which to build positive cash flow and grow profits. It is often the least understood and most poorly managed area in the company.
OK give us an example to show what you mean – remember I am not an accountant just a business owner myself!
If a company business carries stock or work-in-progress for an average of 80 days, takes an average of 36 days to collect monies due from customers and pays its suppliers in an average of 26 days, the business will have a Cash Conversion Cycle of 90 days (80 + 36 -26). See not so difficult! But the value of the Cash Conversion Cycle lies not so much in the single number (90 days in this instance) at a point in time. This is just the starting point, which can be compared against the norms for the industry in which your business operates.
Also for example this business has sales of £1 million, a gross margin of 35% and overheads of £200k giving a profit of £100k. The value tied up in the Cash Conversion Cycle is as follows:
Stock/WIP: = £650,000 x 80/365 = £142,446
Debtors: = £1,000,000 x 36/365 = £98,630
Creditor: = £850,000 x 26/365 = – £60,547
So in this example, £180,529 is the value of working capital needing to be financed i.e. £142,446 + £98,630- £60,547.
The real benefit comes with looking at and improving on the Cash Conversion Cycle days over a period of time. What if you, as the business owner in the example above, managed to reduce stock/WIP carrying days from 80 to 75 and debtor days from 36 to 32 and increased creditor days from 26 to 30? Well the simple answer is that you will have access to more ‘free’ (in all senses of the word) cash.
To read more about the cash conversion cycle have a look here to get the full definition .
Tight control of working capital becomes even more important if you are growing your business.
Suppose sales were going to increase from £1 million in sales to £1.5 million. While an MD or business owner may be expecting to have more cash due to higher profits, the reality can often be quite different. In addition to financing the increased working capital needs of the business, there will probably be a requirement for capital investment in infrastructure and facilities.
Dramatically increased credit lines may have not been agreed in advance. This does not mean that growth is bad the important thing is making sure these things are planned for well in advance.
In addition, measures like ‘Days Sales Outstanding’ for monies due from customers, ‘Days Inventory Outstanding’ for stock/work-in-progress, and ‘Days Payable Outstanding’ for amounts due to suppliers need to be closely monitored and targeted for constant improvement.
As you can start to see, understanding your working capital requirements is not only crucial, it’s also something that takes a bit more thinking about than the snapshot approach most owner managers apply to their bank accounts.
But let’s say you have a good idea of the working capital you need to accelerate, sustain or re-launch your growth. How you finance this working capital is critical to your success.
In an Ideal situation businesses should finance working capital through adequate upfront capitalisation by owners, and then by reinvesting profits in the business.
Other forms of working capital finance are often needed especially in the day-to-day operations of growing businesses. These may include:
- owner contributions and loans
- extended supplier terms
- bank financing trade debtors and inventory
- revolving business credit card debt
- factoring of accounts receivable
- sale and leaseback arrangements.
This does not include loans for long-term assets (buildings and equipment), which should be financed with term-debt secured by the relevant assets.
Managing working capital so that a business has the money it needs at all times requires hands-on management. The methodologies used to do this will vary in application from one business to another. The cash conversion cycle should generally be used to track a business over several consecutive time periods and compared to multiple competitors. By tracking this over time then signs patterns of better or worse value can be more informative than in a single period taken out of context.
The more cash a business has, then it is stronger but an excess of cash can also be a sign of operating inefficiency. If bank deposits are high, is the surplus cash being invested wisely? Could the business internally produce a better rate of return on excess cash than is externally available? This could be achieved by investing in newer technology to become more efficient or to acquire complementary businesses.
The next articles will discuss the next steps in the profit improvement process we follow – so keep coming back here for more. Or if you cannot wait and want a free discussion with Phil about the specifics relating to your business them call or email directly our details are here.
