Answering the question “do we have enough capital” seems pretty straightforward. But covering short-term expenses isn’t always that simple.
Many factors can impact a business’s capital requirements: Just to name a few:
- Unexpected fluctuations in demand
- Shipping and supply chain disruptions
- Fluctuating costs of raw materials
- Lost or damaged materials and goods
- Late customer payments
- Poor seasonal planning
- Poor growth planning
In this article, we take a realistic look at how poor capital management can jeopardize an otherwise healthy business. We then present some best practices to help your business stay in good financial health.
How can a profitable business have negative working capital?
A business can have expected profits but still become insolvent before it gets a chance to report them if it doesn't have sufficient liquid assets to fund operating expenses and current debts.
This occurs when a business prioritizes long-term goals over short-term obligations.
Growth initiatives, for example, typically require more working capital. Launching a new product line, expanding into a new market, or taking on a new client all require an upfront investment that increases current liabilities.
These projects may not bring cash back into the business for months or years. In the meantime, the company will need to have a cash cushion, or sufficient current assets, to cover the cost of expansion.
When capital requirement runs away from projections
Even a simple surge in demand can create cash problems.
Let’s say a home furniture manufacturer receives some unexpected media attention. Suddenly, they have double the orders they were expecting. To fill the orders, they must purchase more lumber, ramp up production, and pay workers overtime.
The only problem is, the cash from these orders doesn’t trickle back in until the furniture is delivered, months later. In this case, accounts payable are due ahead of accounts receivable, and there may not be enough cash on hand to pay suppliers and workers on time.
Avoid a capital crisis with these 6 best practices
To avoid such a scenario, you’ll need to keep a healthy cash cushion and budget for near-term and long-term expenses. Consider these best practices for working capital management.
1. Analyze historical cash inflows and expenses
This is especially important for businesses that operate on seasonal cycles. For example, a pool services company may make 80% of their revenue in only 6 months of the year. During the off-season, they still have operating expenses such as payroll, utilities, rent, and inventory. They must retain enough capital to pay expenses through the low season
2. Harmonize accounts payable and accounts receivable
If you are paying vendors within 15 days but only collect from customers every 30 days, you may need to renegotiate payment terms on both ends. Ask suppliers for more favorable payment schedules or adjust your procurement quantities to bring costs down. Offer your customers rewards for early payments, and penalties for late payments. Consider requiring a deposit for new clients and projects.
3. Factor in current business conditions
Changes in the price of raw materials, shipping costs, and contracts signed or canceled, all impact your cash requirement. Adjust your projections accordingly.
4. Digitize order management
Eliminate errors and shorten time to payment by digitizing your order management processes. With a digital product catalog and online ordering, you benefit from instant digital orders that can be seamlessly passed to warehouse teams and shipping partners.
5. Automate invoicing
With billing integrated into an online ordering system, you can automatically generate customer invoices and payment reminders. With a best-fit software solution, you can also automate credit approvals and offer more diverse payment options such as purchase order, credit card, or ACH bank transfer.
6. Pursue lean inventory management
Excess inventory means less cash on hand. By optimizing inventory levels, you can free up capital to invest in marketing or other activities that attract new customers and build your business.
Working capital management to achieve business goals
Working capital needs vary by business and industry. Companies like grocery stores that sell fast-moving consumer goods don’t need as much working capital because they sell a high volume of goods every day and can quickly generate more capital.
On the other hand, makers and manufacturers, and B2B organizations in general, deal with longer customer buying cycles and may have a significant delay on return for assets invested. These businesses must understand working capital and plan for their cash needs.
Whether your business wants to launch a new product line, capture more market share, or simply offer the best quality service in a competitive environment, you need to properly manage working capital to achieve business goals.
Want to explore ways to boost your business’s working capital? Visit Inxeption Capital to learn about our financial services.