The importance of having working capital is best understood as 'costs expended before payment received for goods/service provided to the customer'. Therefore, no capital means no produce and no customers, which means no capital...
Working capital has three categories to balance:
(i) Stock Costing
Raw materials, work in progress (WIP) , finished stock and 'bought in' items are valued at the 'lower of cost or net realizable value': basically, only the cost of the raw materials can be added to current assets.
You should not maintain more than two weeks stock if deliveries can be made weekly, and the cost of delivery is not chargeable to you.
(ii) Debtors
The total amount due to you by customers that you have supplied credit to.
This figure should not exceed 15% of your annual turnover.
(iii) Cash
All cash in hand or at the bank that is 'available' for you to use.
The amount of working capital in a business is an important factor when assessing risk (i.e. credit assessment). The ratio, known as the 'current ratio', is Current Assets divided by Current Liabilities and is used to assess the ability of the business to meet current/short term liabilities: this means has the company enough cash and stock to pay immediate suppliers, bills and staff wages. A ratio known as a 'quick ratio' excludes stock and is a simple question of cash, or lack of it!
Current Ratio
Current Assets (say) £900,000 divided by Current Liabilities (say) £600,000 = a Current Ratio of 1.5
A 'current ratio' between 1.0 and 1.5 is average: less than 1.0 is a risk: over 1.5 is not a risk. However, this is only one ratio, many
ratios are used to assess a business risk.
Getting the Timing Right
Working capital is all about timing:
cash flow timing. Get it wrong and suppliers withhold deliveries, staff cannot be paid and sales dry up as you cannot produce your services. There are a number of steps you can take to ensure sufficient cash flow at crucial times.
Work out how much cash you need from the period the raw material is delivered to your customer paying you.
a. Lead Time = 80 Days
b. Raw material delivered Day 0
c. Goods produced at Day 20
d. Goods finished (waiting delivery to customer) Day 25
e. Supplier paid Day 30
f. Customer invoice paid Day 80
g. Period of self financing 50 Days (e - f)
This means you must have enough cash in the first instance to fund your business for 50 days. To calculate how much you need, divide your annual turnover (projected figure or last years) by 365, then multiply the figure by 50 to get the 'rough' figure you need in cash (working capital). An example:
Turnover £500,000 Divided by 365 = £1,370 x 50 = £68,500 required to finance lead time.
A further precaution is to ensure low stock levels at all times. Increase 'c.' (above, Goods produced) by 20 days and the above £68,500 suddenly becomes £95,900! (frightening).
Also, odd as it at seems at first, you should keep working capital at a minimum level. A high level of working capital means high debtor and stock levels: debtor levels should run at about 15% of turnover, and stock levels at about 1 to 2 weeks production (depending on industry of course). Your cash should be paying off loans, upgrading machinery or invested in training and new premises: make the cash work. High debtor levels and a bank overdraft spell insolvency.
Use a
cash flow forecast and
cash flow statement to control your working capital up to 12 months in advance. This will allow you to estimate utility, building, staff and expense costs with a high-degree of accuracy.
Breakeven
Within the cash flow forecast you need even sales figure to target as a 'must do' scenario. The definition of breakeven: "The level of sales (by volume or selling price) at which sales equal costs (no profit, but no loss either)." This means that if your total costs for running your business for, say, one month was £5000 and you sold carpets at £1000each: you would need to sell '5' carpets, or put another way, £5000 worth of carpets.
Too Many Sales!
The paradox of '
overtrading' is mostly about working capital. Getting the 'big sale' that doubles your turnover has been the downfall of many successful businesses. Using the above equation in 'Getting the Timing Right', the period of self financing is unchanged, however the daily amount required to fund your business will ensure you run out of cash half-way through the lead time. This means your suppliers stop deliveries (as they cannot buy raw materials) and your new big customer starts cancelling orders and withholds payment to you, you ignore your smaller customers to fulfil the order: an order that is loosing profitability at lightning speed...
The Way It Should Be - the 'Working Cycle'
You put capital (cash) into your business...
You purchase raw materials
You pay suppliers
You pay staff costs
You deliver service/goods
You allow a credit period
You raise an invoice
You receive money
You purchase raw materials...
Pre-fixing each stage with 'You' is to ensure that you see, quite easily, the dependence of working capital upon your actions and not your suppliers or customers actions. You must work to maintain a strict regime within your business that will allow for emergencies, but not for poor financial management from any key area within your working cycle. If your customers do not pay you as agreed let them know that you cannot allow such action within your financial system, and that if they default again you will have to consider supplying alternative customers (wouldn't that be nice!).
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