Understanding Operating Capital: How Do You Safeguard Your Business?
Does your business have enough cash flow? Operating Capital (Working Capital) is the cash that a business has for daily operations within a period of time. Every business depends on this as having no cash is ultimately a big reason as to why businesses fail. Whether a business is small or large, a lack of cash can be a huge problem for them and, therefore, cash management and planning for future cash flow is a key factor in the continued existence of a business. The success of a business can be measured by how well they manage cash on a daily basis.
This explanation is easy enough to understand but putting it into action can be quite complex. Cash is not a constant factor and will change frequently day by day, therefore, managing it can be a tiring ordeal.
Working or Operating Capital can be found by getting the total Current Assets available and deducting the total Current Liabilities from it. Current Assets are the assets available to the business that can be converted to cash within that year, example, Debtors, Inventory and Prepaid Expenses. Current Liabilities, on the other hand, are the liabilities that are due within that year, example, Creditors, Short Term Loans and Accrued Expenses.
Working capital is classified as one of the most important assets of any business and they use a multitude of ways to monitor and keep the cash flowing. As a new or small business, initially working capital will come in the form of investors. This could be from angel investors, friends & family, savings or venture capital. More seasoned businesses have other venues to choose from such as bank loans or becoming a publically listed company and selling shares on the market. No matter the size of the business, they are always looking for methods to be cash flow positive so as not to affect the daily running of the company.
Let’s summarize the whole idea through an example.
Company ABC has recently noticed a significant growth in business. To keep up with this growth, they need to have more capital in hand in order to increase the production of their goods to match the current and near-future demand levels. They will first do an evaluation of their current working capacity to check if it is possible.
Current Asset value as of now
Cash in Hand – $10,000
Cheques – $5,000
Debtors – $10,000
Inventory – $5,000
Total Value = $30,000
Current Liability value as of now
Creditors – $20,000
Accrued Expenses – $5,000
Total Value = $25,000
Operating Capital = $30,000 – $25,000 = $5,000
After their evaluation, Company ABC has only $5000 in hand for the year which can be used for this expansion which is not nearly enough to match their needs. Therefore, they now have to make a decision on how to improve their current cash flow level. A short term bank loan would be the most beneficial decision right now as they need immediate cash in hand.
Benefits Of Having A Healthy Working Capital
· Working capital in hand is the backbone of smooth running in everyday business life. All future debt obligations, future expansion and sudden requirements of cash are all dependent on how well the working capital is managed in the business. Keeping a healthy level of cash, accounts receivable and liquid inventory constantly available will ensure that the business will not stutter from its path to growth. It will also give them more options as a financially secure business like being able to give out products on credit which will lead to increased sales levels. And these increased sales would need the additional stocks to be purchased which can again be satisfied if their working capital is at a healthy amount.
· The current or quick ratio that you read about earlier plays a part when it comes to lending. The reason small businesses have to depend on savings or investors is that banks or other financial institutions will not offer them a loan without proper collateral and proof that they can pay it back. The current ratio shows a value of how well a business is able to pay back their debts instantly, and so if a business is able to maintain a highly positive ratio constantly, then they will have more streams of cash flow into the business when they require it. A lot of businesses end up closing down as they run out of cash too quickly and are not able to bring in more cash to continue running. This big risk is eliminated by the proper handling of their working capital.
· Working capital is also more beneficial to certain types of businesses compared to others. Having a healthy level will give a buffer to a business in terms of businesses that operate on a seasonal basis. Example, a holiday company that relies on a couple of seasons a year to do business must find a way to continue running on the off-season days. During the times when they are busy, they must take more precaution to manage their working capital better so as to keep the daily transactions going in between that season to the next. These types of businesses can easily fail if they do not have this cash in hand.
· Having a good working capital level will also give the business an edge over its competitors in some situations. If the country that the business is operating in suddenly has a downturn, then the extra cash that the business has will allow it to survive even while those around slowly close down. Or, for example, if the business wants to make a strategic move and gain more market share, then they can lower the prices of their products below that of their competitors and use the working capital excess they have to make this happen. If these products are being sold below costs, then competitors may not be able to keep up and so the company will be able to grab that market share and grow as a whole.
The Operating Capital Cycle
This cycle shows the amount of time that the business takes to convert the Net Working Capital (Current Assets minus Current Liabilities) into cash. This will show how optimized their cash flow is and how soon they are able to make assets liquid in need of urgent cash.
A typical business would operate by using credit transactions between short periods to get their products moving. By keeping this in mind, we can see how a working capital cycle usually works during that time. Here is an example:
Thus, we have three values here that we use to add on to the operating capital cycle formula:
Operating Capital Cycle = Inventory Days + Accounts Receivable Days – Accounts Payable Days
Operating Capital Cycle = 50 + 20 – 60 = 10 days
The above value means that the company will be out of cash from that transaction for 10 days before they get it back.
Now, this is just an example that we used where we assume that the company only has one supplier and will only make one transaction during that period, but in reality, they will have multiple transactions happening concurrently which will make it harder for them to keep track of all of them. This cycle will allow them to have a general understanding of how fast cash is going out and coming into the business.
The working capital cycle value can have both a positive and negative value. The positive value, as shown above, means that the business will have to wait for a while once they have sold off their goods in order to pay back their bills. However, there can be instances where the opposite happens and that is when the cycle has a negative value.
A good way to understand this is by taking another typical business example. Above, we assumed that the business will sell off their products to the customers in the form of credit so there is a waiting period before they get their cash back. However, let’s assume that the business will do credit transactions with their suppliers and only cash suppliers with their customers.
In this way, the accounts receivable days will reduce to zero. So using the same example above, let’s calculate the working capital cycle again:
Operating Capital Cycle = 50 + 0 – 60 = – 10 days
The value has now dropped to a negative which means that the business will already have the cash in hand ready to pay their suppliers before the date that they were due to pay it off.
Improving your Working Capital
Now that we know just how important operating capital is to a business, we can identify ways to how they can improve and manage it in the long-term. Not all businesses that are profitable may be managing working capital well. It depends on the business cycle that the company goes through. This can depend on if the business is a seasonal business, has a high debtor day ratio, and more.
The first thing that the business must identify is their cycle. Once they know the period of cash inflows and outflows in the business, they can make a plan to improve it. Certain businesses need a cash buffer to keep running whereas others may need a lot of cash on hand all the time to manage their daily transactions.
One way of improving the working capital value is by reducing the overall use of the working capital as a whole. This means reducing the amounts spent or optimizing how effectively cash is spent in the business. There are a few ways this may be done:
We all know that the more a business receives demand, the better off they are. However, if the business is operating on credit and the payments take quite a bit of time to come back to them, then sudden increases in order quantities may not be good in the long-term.
By increasing production, the business is also increasing its overhead costs, which means that the business will face a much higher cash loss until the time that the customer pays the amount back. This makes the business vulnerable during that time due to the lack of cash. So, they have to be careful when it comes to increasing supply or production and should make sure that they have sufficient cash to run in the future. (At least a 3-month buffer).
2. Reduce inventory costs
Optimizing the way they purchase raw materials and improving their production capabilities will reduce their costs in the long run and ultimately lead to higher cash inflows.
3. Reduce constant cash withdrawals for personal use.
4. Purchasing fixed assets from the daily transaction value should be avoided unless absolutely necessary. Finance should be set aside separately for these purchases.
By checking the financial health of the business by using the ratios shown above and forecasting cash flows for the future, the business can see how well they are doing at the moment as well what necessary steps they’ll have to make for the future.
And as we spoke about before, reducing the working capital cycle by improving the average debtor days and maintaining good credit scores with their suppliers, can improve the working capital levels of the business to best support them in the long run.