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Working capital and understanding this key concept

Working capital and understanding this key concept

As a small business owner, there’s no doubt you’ve heard the term ‘working capital’. It’s a critical component of any business so it’s essential that you understand what it is and why it’s so important. Simply put, working capital refers to the sum of funds currently in use in a business to support their operations. The specific components will vary based on each individual business however typical examples include money owed to suppliers, the ATO, stock on hand, or work in progress.  As you can see, each of these components will usually be variable in nature, if you’re lucky, they’ll follow a seasonal cycle – making it easier for you to plan ahead. 

The consequences of being ignorant of your working capital requirements can be severe, trust me, I’ve seen it all. You may not be able to pay suppliers, fulfil customer orders or cover your mandatory debt repayments, all of which could spell a (working)-capital punishment for your business. So let’s take a look at how your working capital position can impact your cash flow as well as some tips to identify and fix common small business working capital mistakes.

The Importance of Effective Working Capital Management

Why do most businesses fail? Insufficient cash. No business can escape the necessity of healthy cash flow. Cash is needed to meet the everyday requirements of business operations so it’s simply essential that you have enough of it. There are likely multiple ways your business generates or pays out cash. The most common issues arise when customers delay their payments to a business as you’re not receiving the cash when expected. What if a supplier requires you to make payment upfront, or changes the terms of your supply agreement? That’s less cash available to your business. This is why staying on the pulse of your business’ working capital requirements is so essential. If you are unable to pay debts as they’re due, you might be trading insolvent. And that’s a serious issue!

“Effective working capital & cash flow management can mitigate external risks”

Effective working capital management can mitigate external risks. Recently in Australia, construction companies of all sizes have come under pressure from a seasonal downturn in the property market. Over 550 construction companies went under last financial year. The highest profile being Ralan Group, with debts of $500 million and leaving 2,300 off-the-plan apartment investors out of pocket. Given the market is now picking back up, managing their working capital and cash flow more conservatively over this critical period may have ensured their ongoing survival.

How Does Cash Flow Impact Working Capital?

The ‘cash cycle’ refers to the outflows of cash from the business, such as paying suppliers, and the inflows of cash to the business after revenue is generated. There’ll usually be timing differences between the two, making it important to understand the relationship between the working capital requirements of your business and how it will impact cash flow at any one time. 

4 Working Capital Mistakes and How to Fix Them

  • Holding on to old stock

Don’t let it get old! Actively liquidate aging stock earlier in the cycle. If you get stuck, make sure to use all channels to offload this stock as fast as possible – run online sales, utilise digital marketplaces or even open pop-up stores to convert sitting stock to cash fast.

  • Not implementing working capital management process

Get back to the basics. Invoice correctly AND on time. Chase up payments from outstanding debtors. Renegotiate with suppliers and reduce any other unneeded overheads.

  • Being too slow to fix an inevitable cash squeeze

Don’t be afraid to negotiate and take immediate action. Depending on your business, you could start issuing pro-forma invoices to your customers in order to get paid before items have dispatched. Chasing up unpaid debts? You need the cash, get personal. Give them a phone call and work out a plan to help them pay you if needed.

  • Ignoring opportunities to improve your funding profile

You could be ‘over-trading’ or trying to grow beyond your financial means. Consider taking out a business loan or other business financing facility to support your increasing working capital requirements over the long term.

That’s all from me! Best of luck managing your business’ working capital requirements, until next time,

Jason Smith