Irrespective of the stage of a business's life cycle,
managing the working capital is extremely important. During
the growth phase, many businesses have failed due to growing too
rapidly, and not having the corresponding cashflow to keep up with
the expanding needs of the business.
Meanwhile, mature businesses need to maintain sufficient working
capital to ensure funds exist to meet liabilities as they fall due
and to take advantage of business opportunities as and when they
There are two fundamental questions a business should ask itself
when managing working capital. The first is how much working
capital is required and the second is how should it be funded? A
good indication of the working capital requirements of a business
can be determined by the "cash conversion cycle". This is
the length of time from the purchase of inventory to the receipt of
cash from customer sales. The length of this cycle can be
influenced through the management of debtors and creditors.
Other financial measures that can be used to monitor working
capital requirements include debtor days, debtor turnover,
inventory days, inventory turnover, creditor days and working
capital days. Monitoring these types of ratios over time can help
identify problems before they manifest themselves in other more
damaging ways, thereby enabling pre-emptive action to be taken.
Tangible "best practices" that can be adopted to
manage accounts receivable (ie cash inflows) include establishing a
credit policy, making invoicing clear to facilitate payment,
invoicing earlier, reducing payment terms, following up on overdue
accounts, offering early settlement discounts and stopping credit
to debtors that don't pay. Such practices need to be balanced
against their potentially negative impact, such as customers going
elsewhere because of unfavourable credit terms.
Conversely, managing cash outflows is also important by taking
advantage of early payment discounts, prioritising suppliers, only
making payments when they are due, ensuring invoices are checked
for accuracy before payment, negotiating extended credit terms or
putting procurement practices in place that are price driven, not
relationship driven. However, care needs to be taken to ensure
continuity of supply of materials and inventory.
Finally, inventory management is an important aspect of working
capital. Techniques can be utilised in order to determine the
optimal level of inventory a business should hold, and the ideal
re-order point. A common model that is used is the "Economic
Order Quantity" model which determines the optimal amount of
inventory a company should order by balancing ordering costs and
carrying costs. Other considerations also include calculating
re-order point so as not to run out of stock, and the consideration
of holding "safety stock" to avoid shortages.
Whether your business is starting up or well established,
managing working capital is integral to success.
The global economic slowdown is having an adverse impact on many businesses, often resulting in lower cash flows.
Some comments from our readers… “The articles are extremely timely and highly applicable” “I often find critical information not available elsewhere” “As in-house counsel, Mondaq’s service is of great value”
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).