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This article, where our MD, Tejas Goenka, talks about how good understanding of your working capital would help you improve your business’ overall efficiency and productivity, was published in yourstory.com on Nov 16, 2019.
Sailing through the treacherous waters of the business world is no joke, and we know that first-hand. Driving your business just relying on passion is not enough in this competitive space, therefore, you require a whole lot of other relevant skills to stay afloat and flourish. While there are numerous important aspects which you must be aware of in order to become successful as an entrepreneur, one of the most crucial skills is that of recognising the need and possessing the ability to understand key financial aspects and draw conclusions that would benefit your business. Now, this doesn’t mean that you need to acquire end-to-end accounting skills to run your business, but a good understanding of your working capital would definitely help you in improving your business’ overall efficiency and productivity.
Working capital serves as blood circulation in any enterprise. Optimisation of working capital can help the business become much efficient and competitive, thereby allowing for a consistent growth. Return on working capital is an excellent indicator of whether the company’s capital is deployed with the right customers and in the right inventory. Managing these two areas efficiently can unblock a lot of working capital. Let us understand this with an example:
A lot of working capital could be blocked in the form of cash which is extremely crucial to run a business smoothly. While your books might show that your revenue is getting generated with the fast movement of your inventory, it doesn’t necessarily mean that you have cashflow in the system. A lot of capital gets stuck with the debtors who have longer payment days despite buying ample inventory. It is imperative that you watch the credit terms that you provide to your buyers after carefully checking their payment history and substantial impact on your cash inflow. The faster you convert your receivables into cash, the higher the cash available for business. Timely and efficient management and collection of accounts receivable will be key for positive working capital impact. Let us look at how cash management and cash flow projection will give you a clear picture of your company’s financial health.
When it comes to cash flow, good understanding of receivables and payables is critical for efficient forecasting of cash availability. Having complete visibility of committed payments and projected inflow in the form of receivables can help businesses in planning the applications and outflow of cash thereby avoiding situations where businesses experience cash crunch. Efficiency in cash flow projections can be very effective in planning of investments, asset creation or repayment of loans and liabilities.
In the same light of efficiently managing working capital, understanding the payment performance of debtors is critical. Each firm has its own credit management policy based on which it decides to provide a timeframe for debtors to pay their dues. The key function of credit management is to optimise the sales at the minimum possible cost of credit.
Treating payables with equal importance as receivables also helps the business in becoming more efficient. Accounts payable is the short-term debt which the company is obligated to pay. One of the key outflows of cash is towards your suppliers. Taking full advantages of credit period and delaying the payment as far as possible within the credit terms will help you to balance the cash outflow and inflow. Considering vendors who offer flexible payment terms and discounts on earlier payment will help here. Ensuring average time to collect receivables is significantly shorter than its average time to settle payables helps to in meeting working capital needs of the business. This definitely requires better cash flow projections but in turn strengthens the relationship, reputation and better negotiating position.
The other important aspect impacting working capital is inventory. Business practices in SME environment are so diversified that in most cases, the decisions are based on elements like schemes, better price deals or also relationships. Most of the times these decisions are not reconciled with the business needs. These ad-hoc decisions lead to either over-stocking or situation of dead inventory. Adopting a slightly better approach and practices like efficient re-ordering cycles considering Reorder levels, lead time, consumption/sales patterns and minimum quantity of supply etc. can help the business in optimizing inventory carrying cost. This will not only free up the blocked capital but will also prevent situations like dead/outdated/ slow-moving /high-cost inventory in stock thereby preventing losses due to unmanaged purchase practices. Managing sufficient stock to meet the forecasted demand will help to mitigate the risk of cash blockage and ensure the right investment of money into inventories.