Understand working capital
Working capital is the lifeblood of your business. If we imagine your business to be a car, working capital is the fuel.
It is the business’s energy, what keeps everything moving, powering all the different parts so that they continue to spin. Without it, your business would simply be a big, expensive clunk, just like a broken down car. So how do we define it exactly? Working capital is the amount of short term assets, or ‘current’ assets available to the business. Things that can reasonably be turned into cash in the short term, such as cash, inventory and accounts receivable, all contribute to working capital. On the flipside, current liabilities detract from working capital. Things such as creditors and bank overdrafts are good examples of this. Working capital is mostly looked at in ratio form: Working capital ratio = Current assets / Current Liabilities The challenge is to ensure that your working capital is always at a healthy level. Obviously the higher the working capital the better, however, there is such thing as too high. If a business has a working capital ratio higher than 2, this can signal various inefficiencies in asset management. On the other hand, a working capital ratio of lower than 1 signals an obvious shortage of current assets, meaning the business is at immediate risk of defaulting on its debts. While the optimal level of working capital will vary per industry, a general guideline is that the working capital ratio should fall between 1.5 and 2. Anything outside that range would signal that some improvement should be made in managing the business’s short term assets. Some of the more common methods to improve working capital are:- Offer discounts to offload high levels of inventory
- Chase up debtors and cut credit limits for bad customers
- Offer discounts for cash sales to avoid an increase in debtors
- Review the inventory order process to prevent over-ordering
- Long term financing to cover short term debt
