As we all in our business work towards creating a perfect structure, we also closely look at the adequacy of funds that are required for our business.
We often think and at times ask, “how much money is required for our business?”
It is evident that investment in business consists of major capital outlays that include plant and machinery, office equipment and other fixed assets. We sometimes overlook the fact that to run a business, besides the capital outlay we also require funds for the operations of the business (working capital)
So, what is working capital?
Working Capital is essentially defined as the funds that are required for day to day operations of the business. It consists of mainly the cash required to pay expenses like salaries, stocks that we hold in our premises to trade/sell and debtors that owe us money for the stocks/services we sell.
It is important for businesses to really understand how they manage their working capital efficiently.
The main strategy of every business should be to rotate their cashflow such that the cash that goes to buy stock is sold quickly and we get paid immediately. However, in the real world, it does not work like this always.
Therefore, it is important to understand the components of working capital and assess both the controllable and non-controllable factors.
Cash rotation as explained is simply the churning of “cash to stock to debtor to cash “cycle. A business that can turn around cash in say a 3-month cycle is far more efficient and profitable then say a business rotates cash in 4 months.
In simple terms if a business that can churn around cash of $ 1 Mil ( working capital) , 4 times in a year ( in a 3months cycle) would have an annual cost of sales of $ 4 Mil compared to a business that churns a $ 1 Mil , 3 times a year and have an annual cost of sales of only $ 3 Mil.
So, you can see how important the concept of working capital efficiency is to improve sales and profits.
Many businesses fail because their funds from operations do not meet their overall business requirements. This could be due to following reasons:
a) Excess holding of inventory (stocks) that is beyond the industry norms. Say if a business of office equipment sales is supposed to hold 2 months of stocks (in technical terms call DII (days in inventory) and if it say has a DII of 3 months , the additional stock it hold eats into the working capital funds and could potentially create issues of wear and tear and further losses.
b) Similarly, all businesses have credit terms with their clients. If there is a leniency in collecting money from the debtors, it will create issues of bad debts and write offs. If credit terms are 30 days ( in technical terms DSO (days sales outstanding ) but actual DSO is 45 days , it is potentially a working capital issue as there is 15 days of additional credit being provided in market , that will impact cashflow rotation and profitability.
c) Cash from operations being used for non-operational funding requirements like investing or financing purposes. This factor could be a single major risk for a business as owners may assume liquidity and make drawing, buy cars, take loans, etc. If the working capital is siphoned out for personal expenses or non-operational purposes, business would struggle or fail. They would require further loans and hence incur more debts.
d) Potentially there is another area of concern. Usually business owe some money to their creditors. These creditors could be the entities from whom you buy stocks or receive services. Some of the creditors may offer you a credit of say 15 days to 30 days to pay up their bills. If a business overlooks these payments and spends their working capital on other non-operational items, there could be potential liquidity problems.
What is required is a pro active Management Information System (MIS) that always keeps a track of the Cash Flows mainly from Business operations. Business owners need to understand their working capital requirements on an ongoing basis. Some of the suggested ways could be:
a)Efficient Reporting system that always highlights the important ratios like DSO and DII for the business. This should be compared to industry norms and benchmarks. Variances should be highlighted and understood so that management can take an informed decision.
b) Cash Flow Analysis where businesses track their Cash from operations and separate it from their Cash from Investing and Financing activities. It is important to always know where the money is coming from and where is it going.
c) Proper expense budgeting and planning on a monthly basis to ensure that all expenses are taken into consideration. Some businesses are cyclical and may have abnormal expenses like say a big marketing spend / advertising. Planning can ensure that there are enough funds available for the event and not spent away on some other less essential expense that can wait.
d) Profitability Analysis is very important as it is the ultimate parameter to understand if the business is profitable. If a business is merely rotating capital and not generating profits for the owners, it will ultimately close.
* Author: Vic Singh, CA, ADFP – Virtual CFO, Chartered Accountant and Financial Planner, helping business clients with their business advisory services and setting up systems for improving their profitability, productivity and financial efficiency.
