Tips on managing working capital for resilience and growth
At a glance
Here’s a snapshot of advice from our interviewees:
- Working capital is essential for small business resilience, and especially important for small businesses that are seasonally dependent.
- Working capital is simple to figure out and gives an accurate picture of your business liquidity.
- Managing inventory, cash flow and accounts receivable are all critical to maintaining the right amount of working capital.
What is working capital?
Simply put, your working capital equals your current assets minus your current liabilities.
“It’s the amount of cash your business has after factoring in short term debts like accounts payable, payroll, tax, and other loans and debts,” explains John White, accountant and business development specialist at Business One.
Your current assets will include your accounts receivable, prepaid expenses and inventory. If, for example, your business has current assets of $80,000 and current liabilities of $50,000, then your working capital is $30,000.
“Working capital provides a snapshot of your business’s liquidity,” says John.
Isn’t that the same as cash flow?
Not quite, though they are very closely related.
“You might have positive cash flow, but negative working capital if your business is carrying large debts,” John points out.
So, does a small business always have to have plenty of working capital? Not necessarily.
“If your working capital is low, your business might struggle to grow,” says John. “But your working capital can also be too high – which is a sign you’re not properly reinvesting your cash. Growth may mean a low amount of working capital, but this is fine, if properly managed.”
Do I really have to know about working capital?
“A lot of small businesses could probably get away with not knowing about cash flow and working capital in the past,” says John. “But if COVID taught us anything, it’s that we can’t just keep fluking our way along. We have to be more educated about our businesses and have a deeper understanding of our financial positions.”
This means answering the question “what are your hopes for the future of your business?” with “I don’t have hopes – I have plans” and understanding all the moving parts and where they will go next.
“It’s better to brush chance aside and make success inevitable,” says John. “And while financial terminology can sometimes sound a bit daunting, it’s worth getting a good understanding of working capital. It’s relatively simple and a strong indicator of your business’s ability to manage upcoming expenses.”
Plus, John points out that as your business grows, there may be legal implications attached to managing your working capital. This is because there are legal requirements and liability considerations when it comes to managing solvency. Another good reason for getting on top of working capital.
While John acknowledges that good software can make figuring all this out much easier by automating and streamlining a lot of the work for you, “the best thing is to find a way to do it that works for you. If that means a spreadsheet, then that’s fine. The important thing is to understand it. Then you can start using more sophisticated software to help as you scale.”
How do I manage my working capital?
John has five key tips for managing your working capital like a pro.
- Get on top of your accounts receivable.
Converting your accounts receivable into working capital may require a reform of your methods of collecting customer payments. Not following up on accounts receivable can sometimes be a hindrance as your working capital can get tied up in unpaid invoices. Need some strategies for getting those accounts paid? Check out these tips Prospa collected earlier in the year on how to chase invoices without damaging relationships.
- Get a cash flow forecast.
Look at your current financial position then roll that forward to understand how much you’ll need in the future. Taking the time to get an accurate forecast of when you will run out of cash will help you determine whether – or by how much – you need to improve your working capital.
- Manage your cash.
It may seem like a good idea to pay your bills quickly as they come, but if you find yourself with minimal working capital it is worth reconsidering how and when you pay your bills. Building good relationships with your suppliers before asking them for longer payment terms is also helpful.
- Get a cash injection if it’s needed.
If you don’t have enough working capital, you might want to talk to your accountant about tax financing or consider revolving credit (especially if you are seasonally dependent) or a small business loan.
- Manage your inventory.
While buying in bulk has its advantages, it’s still important to consider whether you can afford to sacrifice valuable working capital for products that could take a long time to sell. Do the maths to ensure you have adequate working capital for the remainder of the business cycle before making big purchases.
After some helpful advice on how to manage your inventory? Check out these expert tips.
What might I need working capital for?
John suggests four reasons why your business might require additional working capital:
- Seasonal differences in cash flow are typical of many small businesses that might need extra capital to gear up for a busy season or to keep the business operating when there’s less money coming in. For example, a beach-based swimwear shop is likely to do most of their trade over just a few months and will need capital to pay the rent through the quieter winter season.
- Almost all businesses will have times when additional working capital is needed to fund obligations to suppliers, employees and the government while waiting for payments from customers. Think tax, holiday pay, increasing stock levels.
- Extra working capital can help improve your business by enabling you to take advantage of supplier discounts by purchasing in bulk.
- Working capital is essential when preparing for growth in the business or undertaking special projects.
Understanding and effectively managing your small business’s working capital can help your business not only grow but build the resilience it needs for the challenges that might come its way.
Speak with one of our small business lending specialists about how a Prospa Small Business Loan could help give your working capital the cash injection it needs to cover the cost of a new investment.
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