Working capital for SMEs by definition is a measure of a company’s liquidity and its short-term financial health. Small businesses often take out short-term loans or financing for their day to day working capital management. This sum of monies is essentially used to keep the operations running while they wait for their accounts receivable (clients’ bills to be paid).
Here are all your questions about working capital answered!
What is working capital?
Working capital is the amount of money a business has to fork out to pay their trade payables/suppliers/vendors, or to cover their daily operational expenses. It is also known as a business’s operating liquidity or cash flow.
How to calculate working capital?
To find out what constitutes as your business working capital, you must subtract your business liabilities from your current business assets. The sum will change according to a SMEs current asset, such as the total accounts receivable paid or outstanding. Therefore, it’s often referred to as a ‘circulating capital’.
Working capital = Cash + Accounts Receivables / Trade Debtors + Inventory – Accounts Payable / Trade Vendors
A circulating capital, as referenced by Gretsenberg is ‘the current assets of a company that are changed in the ordinary course of business from one form to another’.
How to manage your working capital?
Working capital management is a strategy that ensures a business has the ability to satisfy both maturing short-term debt and upcoming operational expenses at any given time. It involves the management of inventories, cash, accounts receivable and accounts payable financing.
In the layman understanding, you will need someone to monitor outgoing and incoming invoices. To make sure your business is being paid for services rendered, and all business expenses are covered. They also must manage your cushion income and extra monies to be sure, that you have enough to tide over, in case of an emergency.
These are the steps you should follow to better manage your SMEs working capital.
1. Maintain the capital you have.
Your entire business management team is responsible for the maintenance and increase of your working capital. Make it a team goal or KPI to make headway in increasing or stabilising your capital. For instance, setting an invoice collection KPI for your finance department or make your procurement team negotiate better credit terms from suppliers.
2. Pay your bills on time!
Similar to personal finance techniques, the faster you pay the credit card company the less you pay in the long run. Paying your suppliers or vendors on-time guarantees a positive relationship with them. Meaning effective negotiating when the time comes for a bit of leeway.
3. Be frugal or careful with expenses.
In larger corporations and businesses, it is easy to overlook the smaller expenses. However, remember that you should only spend within your means. Make this point clear to your employees, that certain benefits are a privilege. Take remedial action if you find that the rules are being overly bent. You can control your expenses by simply setting up approval and spend metrics, for example, the maximum entertainment claim for managerial level is of a certain amount per month.
4. Keep an eye on the inventory.
Try not to overstock or overbuy from your suppliers. An excessive stock might not always be a good thing, especially in businesses dealing with perishables. Usually, excessive stocking is the result of poor communication or planning, override this with regular stock checks. Running an analysis of your average output will not hurt either. To better manage your inventory level, you can calculate the average time period (days/weeks/months) at which your stocks are held in your warehouse (from the time they arrive until the time they are sold out).
5. Alternative Financing.
Bank overdrafts or bank loans can work for businesses in need of larger or urgent funding. However, it does take a toll, as the risk posed to the bank is higher, your interest rates climb. Look for alternative financing or lenders, for short term solutions.
P2P financing has become more accessible for SMEs as of late and can be a great alternative to bank loans. Check out our website for financing solutions that might just work for you.
6. Invoice Financing Solutions
Invoice Financing will allow you to borrow up to 80% of the sales invoice value as soon as you raise them. This will be helpful if you have clients often behind on their invoices or clients operating on opposite billing cycles to your SME business.
Funding Societies offers this service to SMEs as well. All you have to do is submit the invoices to us, and we will help you maintain your working capital!
Types of Working Capital Management
The typical approach taken in working capital management is to engage in short-term financing. Generally, short term interest rates are cheaper compared to long term loans. However, short-term financing incurs a higher risk factor, and could potentially pose a major threat to businesses.
There are a few strategies one could employ to manage their working capital. Taking into consideration the risk and probability factors, each approach has its own pros and cons.
The Aggressive Approach
Maximise profits at a higher risk. This method suggests that the entirety of your business working capital and fixed assets be funded from short-term finances. This way the cost of capital is reduced relatively (compared to longer-term financing) and the approach maximises profit for the business. You could run the risk of a cash shortage or liquidity issue when you fund your working capital and fixed assets with short term finances. For example, you have used an overdraft bank facility (repayable is less than 12 months) to finance the purchase of machinery with a useful life of more than 12 months, say 2 to 3 years.
The Moderate Approach
With moderate risks, come moderate profitability. The strategy suggests that the fixed assets and the permanent working capital are financed from long-term sources. However, the variable working capital is sourced from short-term sources.
The Conservative Approach
As the name suggests, it means that your business takes on low risks and hence a lower profit. This means that both the permanent working capital and the variable working capital are financed via long-term financing. The result would be an increase in the cost of capital. However, the risk of financial fluctuations is also lower.
How does working capital affect a business?
There are several disadvantages to the poor management of your business working capital. If the measurement of your working capital cycle is not sufficient to maintain your business day-to-day, then you have poor management of your capital.
The difficulty in attracting investors
Having a sufficient working capital cycle shows creditors and investors that your company has the capability to pay back their loans or earn a profit. Some creditors view a business without working capital as a risk making it harder for your business to acquire funding.
Business growth deficiently
Positive working capital allows SME business owners to grow. Meeting your customer needs and planning ahead are all good signs of good credit risk. None of which is possible if you don’t have the funds to make it happen. Catering to the flexibility of your business growth is one of the first business models every SME should adapt.
Lack of Financing for Daily Operations
As mentioned previously, a business working capital exists for the purpose of maintaining your business day-to-day. These types of operational costs include inventory purchases, equipment purchases or rentals and employee salaries. If you lack the sufficient funds for payroll, that reflects negatively on your business as a whole.
Slow Improvement to Business working Capital
Businesses that struggle to maintain a good working capital, run the risk of never being up to par. The focus of your cash payments. Revise your accounts receivable policies, encourage your customers to make their payments early or on time. This allows you to build up capital quickly. Find ways to increase your working capital without incurring external costs.
There are countless ways you can improve, maintain or boost your business working capital and make it work harder for your business. We hope you found this article helpful and if there are questions we haven’t answered, leave us a comment!
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