What is the most important focus area for any business? Most SMEs make the mistake of focusing only on the profitability of the business. But liquidity is the other pillar on which a company stands. Liquidity is achieved through efficient working capital management. The concept is similar to a person’s cost of living – just as a certain amount of money is needed to sustain certain expenses like food, housing and health, an enterprise needs a regular amount of cash to cover short term expenses and debts.
The assumption “if you’re generating profit, you’ll have enough cash” is wrong. To ensure growth and development, you need to manage working capital. Working capital management is a major challenge for many SMEs. By keeping the following tips in mind, a lot of these problems can be mitigated.
Arriving at the right number
Before you set out on the path to grow and develop your SME, find out your current working capital ratio. Divide your current assets like cash, inventory and accounts receivable by current liabilities, which include accounts payable like supplier payments, taxes, and payments for long term business financing. If this ratio turns out to be less than one, it means the business does not have enough working capital to settle short term liabilities. While the standard varies industry wise, a ratio greater than 1 implies the business is in a good financial position to grow further.
Too much inventory can tie up a great portion of cash, while also increasing storage costs. On the other hand, too little inventory can result in a loss of potential sales. The solution is to forecast demands on the basis of sales history, which will enable you to maintain just enough inventories. There are a lot of tools that can help SMEs improve forecasting accuracy.
If there’s too much inventory, consider selling some at low or discounted prices – it may cost you less than storage costs.
The best way to ensure proper management of working capital is to send out bills and invoices promptly, which can be accounted as ‘Accounts Receivable’ and increase working capital. It’s important to form good credit practices and processes with clients. While a 30 day payment period is fine, it’s also acceptable to ask for payment within 15 days. Offering discounts to clients who pay promptly is a common practice, but it’s not enough. Track previous invoices and identify slow paying clients.
On the other hand, SMEs can negotiate with suppliers for more favourable terms of payments. Avoid paying out earlier than the payment date. For critical inventory items, you should have more than one vendor.
Create contingency plans
Your SME might be highly profitable, but you still have to prepare contingency plans to deal with unexpected events. Every business has different risk management procedures, which should be established on practical and objective view of working capital needs.
This article was written by Funding Societies, the first peer-to-peer (P2P) financing platform in Malaysia. We provide working capital financing for small and medium-sized enterprises (SMEs); we also offer investment opportunities with returns up to 14% per year. To learn more about us, click on our website here.
You can also see our up-to-date progress and statistics in Southeast Asia here.