Is Your Working Capital Draining Your Business?
About the Author:
Paul Wilton (editor)
CA with degrees in commerce, accounting and information technology. Paul worked overseas in the “Big 4” accounting firms and served as a director at Audit New Zealand before setting up his own consultancy. Author of A-Z of New Zealand Business Law, Paul has over 20 years of experience as a business owner and consultant. He joined FBA in 2004 and is totally committed to providing excellence in quality and value to our subscribers.
Working capital is the term used to describe your short- term or current assets and current liabilities. Current assets typically include cash, accounts receivable, inventory and short-term investments, while current liabilities include accounts payable and short- term loans.
Many businesses fail for this reason
When working capital is not sufficiently funded, your business can run out of cash and face bankruptcy. This occurs because of the time delay between paying for your purchases and receiving cash from your sales. There is a period when you have laid out a lot of money and are waiting for the cash to come in. The more business you do in dollar terms and the longer the gap between cash out and cash in, the more finance you need to fund the gap. The impact is felt in real dollars, plus interest. (See article on Pg 3 on how to calculate the cash gap and work out the working capital funding requirements for your business).
The working capital paradox
Even a seemingly healthy and profitable business can face bankruptcy if working capital is not adequately financed. As your business grows or changes to be more competitive, more and more working capital is required to fuel the growth or change. You will need larger investments in inventory and accounts receivable, as well as cash to fund staff, consumables and other items essential to achieving and sustaining increased sales. It is critical to understand the impact when planning any change, to ensure that you do not expand faster than your cash generation will permit.
Putting cash back in your pocket
Many businesses that have been operating for some time will have built up reserves to fund their working capital requirements. This is a goal for those who have yet to achieve it, and even for those with adequate reserves, it is worth knowing how much cash is tied up in your working capital, as releasing it will inject money into the business or your pockets. This can be achieved by shortening the cash gap or by scaling back on business that is not paying its way.
General funding considerations
It is not good practice to take on long-term debt to fund a short-term commitment. Similarly, it is not recommended to secure your working capital using your family home. Ideally, you would look to arrange an overdraft facility to fund working capital and secure it with those assets (inventory and debtors). Sometimes, especially for smaller businesses, banks leave you with little choice. The one compensating factor is that a revolving credit facility secured by your home will often be quite a lot cheaper than other financing options. If you have unencumbered equity in your business of more than 40% of total assets, you may be able to negotiate better overdraft terms with your bank. When evaluating options, make sure that you understand all terms, such as restrictions on obtaining other forms of finance and all costs such as monthly charges, unutilised facility fees, base rates and margins.
How liquid is your business?
Net working capital represents the excess of current assets over current liabilities and is an indicator of the firm’s ability to meet its short-term financial obligations. It is often expressed as a ratio, known as the working capital ratio or the current ratio.
Current Ratio:
This is calculated by dividing current assets by current liabilities. For example, if you have $50,000 of current assets and $25,000 of current liabilities, you will have a current ratio of 2:1. A current ratio of 2:1 is considered healthy as it indicates that you should be able to use your current assets to pay off your current liabilities. When the ratio approaches 1:1, this may be an indication of looming liquidity problems, especially depending on the size of your inventory. This is because stock may take a while to sell, whereas creditors expect to be paid on time.
Quick ratio, also known as the asset-test ratio:
This takes stock out of the equation and divides the liquid current assets by current liabilities. The liquid current assets include cash and assets that can be converted quickly and easily into cash, such as debtors and marketable securities (such as government bonds and listed shares). A quick ratio of 1:1 indicates that your business can convert its liquid current assets into cash and pay off its current liabilities.
These ratios may be used to understand your current liquidity; the trend over a period of time; and your position relative to others in your industry, where benchmarking information is available. Each of these exercises can trigger alarms and prompt you to take corrective action.
Conclusion
Working capital can tell you a lot about how your business is doing. When well understood and adequately funded, working capital can drive your business to greater heights. When not, it can be a real killer.
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