If you’re a business owner, working capital is an essential part of your daily operations. As well as supporting running costs and special projects, it’s also there as a safety net for unexpected expenses or sudden investment opportunities. Without good working capital, your business is in a risky position, where even a small wobble in your finances can have disastrous knock-on effects.
To help you keep your business in a stronger financial position, here’s a little more about working capital and what you can do to improve yours.
Why you need good working capital
Working capital is the difference between the current assets of your business (excluding cash) and the current liabilities. It is often an important metric used by financial directors and accountants to indicate the economic health of a business.
With good working capital, you’ll be able to buy new materials, equipment and improve the running of your business; the lights stay on and your employees can enjoy a good salary and working environment.
If you end up with negative working capital, it may be an indication that your assets are not being used efficiently and liquid cash is in short supply. Even if your company is expecting money from unpaid customer invoices, not having working capital on hand can be cause for concern.
Working capital is essential for:
Maintaining good cash flow
So that you can fulfil your payroll obligations, tax, rent, bills and other operating expenses.
Bridging payment delays
In situations where clients are late in paying invoices or there are delays in the general income for the company.
Buying inventory
To maintain stock levels and secure new products to sell. Working capital can also be instrumental in taking advantage of bulk pricing where larger upfront payments are needed.
Improving equipment
Such as better software solutions, faster computers or more efficient machinery to future-proof your business and provide the best service possible.
Covering seasonal uplifts or shortfalls
To ensure you can continue business operations during seasonally light or heavy times. For instance, you may be in the hospitality industry and need to hire contractors or temporary staff for busy periods.
Launching marketing campaigns
To attract new clients, retain current ones and increase your overall visibility amongst the competition. While marketing budgets may be part of your general expenses, launching new campaigns usually requires a cash injection to gain traction quickly.
Managing employee expenses
Such as recruitment costs, bonus payments, emergency loans and employee events.
Reacting to the unexpected
No matter how prepared you are, unforeseen problems are an unfortunate part of every business. Broken equipment, structural damage or fines can come out of nowhere. In these situations, having working capital can be the difference between shutting down and braving the storm.
Working with experts
Training and exterior consulting are normal parts of any business development, but often come with a high price. Working capital gives you the freedom to work with the best to maximise the quality of your product or service.
Renovating or expanding
To improve working conditions and office space, based on the size of your team and their needs. Or, if your office is a little long in the tooth, remodelling costs and refurbishment.
Having good creditworthiness
As mentioned above, the amount of working capital you have can be used as an indicator of your overall business health. If you’re looking to establish good credit, a strong bed of liquid cash can go a long way in making you more reputable.
Investing and growing
In cases where sudden opportunities come your way, which can happen any time. A colleague may find a new lead, competitors may go up for sale or the perfect office location might pop up. To take advantage of any of these, immediate working capital is the only way to go.
Getting a sense of your working capital
In a nutshell, working out your working capital is as simple as subtracting your current liabilities (such as the money your business owes to vendors) from your current assets. While each business has its own circumstances, a general rule of thumb is to achieve a 2:1 ratio between your assets and your liabilities. In other words, you want to have $2 in current assets for every $1 of current liability.
However, there is a delicate balance to be struck. As we know, if you have too little working capital, your company has no safety net and will always be facing the possibility of bankruptcy if anything unexpected happens. But, there is also the chance of having too much of a good thing. If you have too much working capital, this could end up decreasing your profits and shareholder value.
Ways you can improve and maintain good working capital
To achieve that ideal 2:1 ratio, there are several ways you can improve your working capital. The following actions all require you to have a good knowledge of your business operations, but are perfectly achievable if you find the right combination. Some may be less realistic than others, but if you manage to address at least a few of them, you’ll be on the right path.
- Automate your debts where possible
By paying your bills and debts on time using automated and electronic payment systems you’ll be able to ensure the money goes out at the same time every month. This will help you keep a more accurate ‘real-time’ track of your working capital and can make your outgoings more predictable. As a bonus, it’ll minimise the risk of having penalties or fees for late payments. - Incentivize your receivables
In an ideal world, your customers will pay on time, but in the real world that sometimes doesn’t happen. Consider providing incentives for early payments (such as a 5% discount), and for those who are consistently late (or don’t pay at all), you may have to end the business relationship and possibly use a debt collection service.If your debtors aren’t paying on time and you find yourself without enough working capital to pay wages, buy stock or cover other daily operations, you can use Invoice Finance to access the cash tied up in unpaid invoices. - Revisit your vendors
If you’ve been working with the same vendor for your products or services, chances are that you aren’t aware of new entrants in the market. There may be other vendors out there which will give you the chance to switch or to renegotiate your current relationship for a better deal. - Investigate your expenses
Take a holistic look at your business and figure out which variable and fixed costs you can reduce. For instance, your utilities may be higher than necessary or you might be able to temporarily cut down on the creature comforts. Every little helps and if you suspend enough of the small things, you’ll be surprised at the improvement to your working capital. - Check your interest payments
If you have loans and other forms of fixed debt, you might be able to modify those rates or negotiate a period of pause. By pausing or modifying your interest payments, you can give yourself the space to rebuild your working capital for a stronger foundation. - Investigate your inventory
Making sure you have enough to fulfil orders while avoiding overstocking is a delicate balance, but maintaining a sensible inventory can free up liquid cash. Do what you can to make sure that finished goods are sold as quickly as possible instead of sitting in storage. If you have a surplus, consider a special discount sale or bulk deal to clear it out before buying more. - Make it easier for customers to pay
Do everything you can to make sure that your customers are able to settle their balances with minimal hassle. Set up automated payment options and online channels to accept and track flows accurately in real-time. This will also make it easier for you to chase late payments. - Look at regional tax incentives or concessions
There may be some tax incentives or concessions that your business qualifies for, which can save you money for better working capital. For more information, talk to your accountant or visit the Australian Taxation Office website. - Resolve your disputes
An unfortunate reality of doing business is that you may sometimes enter into a dispute with customers or vendors. If you are facing any kind of legal action, do what you can to settle it before things move into pricier territories such as lawsuits. Remain civil wherever possible and see if you can set up payment plans or any other ways to reassure the people you owe money to.
Work for your capital
The bottom line is that without working capital, your business may be in serious danger of bankruptcy. How you go about maintaining your cash flow is ultimately down to your individual circumstances, but by using some of the above tips you have every chance of improving your situation.
If you are facing difficult times, talk to us about our business finance solutions; they might just be what you need to get back on your feet for stronger, more stable operations.