Working capital mismanagement is one of the main causes why a small and medium business fails. This is also one of the main causes of industrial sickness. Working Capital is considered lifeblood of any business.
Understanding the key data affecting working capital, how impacts the business, how it can be better managed, what are the sources of working capital, cost of working capital all are very important aspects of the business. Every entrepreneur must not only know about this but shall be savvy about this to survive entrepreneurship.
What is Working Capital?
Working capital is money a business needs to run the day to day business. Which means money required to purchase raw material, pay for the expenses, manufacturing cost, logistics cost and sustain the operation till the sales proceeds are received.
Ingredients of Working Capital
Money is blocked in the business till sales money is recovered.
The main components of working capital are;
Purchase of Raw Material (Creditors)
Production Expenses (Creditors)
Receivable from Sales (Debtors)
In Balance Sheet terms it is the difference between Current Assets and Current Liabilities.
For example, if the production cycle of the business until the goods is ready for dispatch is 90 days, and after that sales credit given to the customers is another 90 days, which means the business would need money for 180 days to run the show before a customer pays.
Suppose the suppliers give credit for 60 days, then the net capital required is for 120 days. (180-60).
The money requires for 120 days is the working capital money.
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How It Impacts?
By now you would know how difficult it is to run the show without working capital. Inadequate working capital can hamper the business cycle.
Business can’t pay the creditors on time, which reduces the creditworthiness.
Business can’t offer more credit to the customers, which reduces growth opportunities. (Ideally less credit to the customers is good but in the competitive environment it hampers the business)
Weak creditworthiness means no bargaining power with the suppliers, needs to pay a higher price.
When a business can’t give more credit to customers, it may have to offer the goods at a cheaper price.
In both the above scenario, the business has to compromise on the prices, which affect profitability.
Weak creditworthiness may compel the business to deal with less reliable suppliers.
All in all, inadequate working capital means inability to pay on time in the market. This seriously affects the business standing of the enterprise. Daily fire fighting for money consumes more of the brainpower of the entrepreneur which otherwise could be used more productively.
Business working with inadequate working capital is like a body running with inadequate blood supply. It can have several side effects.
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How to Better Manage Working Capital?
- Assess Adequate
The number one thing is to know the exact requirement. Inaccurate and less the assessment would make the thing worse.
- Invest Adequate
Bring your contribution adequately. Many times, promoters fully rely on bank money. They manipulate the data. Whereas s banks expect the promoters to bring in the margin money. Inadequate promoter’s investment will always hinder the business growth, reduces the profitability and crate liquidity crisis.
- Borrow Adequate
You need to have an adequate working capital loan from the bank based on your actual assessment. Many time banks do not finance adequately, or business could not borrow as per the plan due to several reasons. In such a scenario, the business suffers liquidity crisis and daily firefighting becomes the business culture.
- Recover ASAP
Recovering fast from the debtors makes the money available in the system. This reduces the burden on the bank’s borrowing and reduces the interest cost.
- Eliminate Production Process Delays
Squeezing here reduces the need for working capital for work in progress.
- Eliminate Delivery Delays
This delays the billing to customers and hence payment time for the goods despatched. This fastens the finished goods turnover and enables quicker cash recovery.
- Negotiate Better with Suppliers
This can give you a better credit period to pay them. When you are flush with funds you can pay early to get some cash discount. This adds to the profitability.
- Plan Better
Just in time is the outcome of better working capital management. When you don’t stock more, your creditors are less.
- Quick Ratio
The quick ratio is an indicator of a business’s short-term liquidity position and measures a business’s ability to meet its short-term obligations with its most liquid assets.
This is calculated as Current Assets Minus Inventories & Prepaid Expenses divided by Current Liabilities.
- Current Ratio
The current ratio is a liquidity ratio that measures a business’s ability to pay short-term obligations or those due within one year.
This is current assets divided by current liabilities. This ratio indicates how many times the business has the money to service current liabilities. Ideally, Ratio above 1.3 is considered good.
- Cash Conversion Cycle (CCC)
This is a very important ratio for working capital management. This shows how quickly how a business converts raw material into cash.
Here is a complete post on the CCC: CCC is the Ratio Every SME Needs to Focus On
These days good companies are operating on negative working capital. Based on their strength, they get more credit from the suppliers and sale on cash or fewer days credit terms to the customers. Their just in time model of production also minimises the need for working capital.
For example, companies like Reliance sale on Cash and gets 90 to 120 days credit from suppliers. This way they don’t need to borrow from the banks for their working capital need. For this kind of companies, all ideal ratio parameters applicable to other companies are different.
Types of Working Capital Loans
Usually, commercial banks finance business for their working capital needs.
- Cash Credit
Usually, Banks finance this loan. This is gap finance. The gap between current liabilities and current assets is financed by way of cash credit loan. Bank asks the promoters to bring certain % of margin money and the balance is financed by the bank.
This is a perpetual loan but renewed every year based on the actual and projected data.
- Purchase Financing
In this case, NBFSs pay the business creditors on the due date. This helps the business to get an additional credit line.
For example, the business has to pay its creditor on 90th day, on 90th day lender pays the supplier. The business has to pay the lender after 90 days. This way business gets 180 days credit for its purchase.
- Bill Discounting
When sales bills are discounted and money is paid to the business, this is known as bill discounting. When the customer pays the bill amount on the due date, this loan gets adjusted and repaid. A business can use the money during the credit period offered to the customer.
- Packing Credit
Bank finance against the export order backed by Letter of credit from the overseas customer is known as packing credit. This loan is availed to buy raw material to fulfill the export order.
Once the goods are supplied to the customer, the bill is purchased by the bank and money is issued against foreign bill purchase. This money is credited to packing credit loan account. This is a kind of bill discounting.
Loan before export is known as packing credit, loan after the export is a foreign bill purchase loan.
- Securitization of Receivables (Factoring)
This is a loan against the sundry debtors of the business. If the business has not discounted the sales bills, they can raise the money against their receivables. The lender would decide the quantum based on the creditworthiness of the customers.
Source of Working Capital
Banks and NBFCs finance the business for working capital. Usually, these loans are against the charge on stock or receivable bills. However, banks while financing cash credit and other such limits ask for additional collateral security. These could be immovable assets or liquid able investment assets.
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This is in short, the world of working capital in simple terminology. Knowing and understanding the play of working capital is vital for every MSME entrepreneur.