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Business owners are often urged by their financial advisors and CPAs to maintain a strong cash flow. Without a robust flow of dollars, even profitability itself may not keep a company in good standing. But many factors play into this essential goal, and our CPAs say one of them is managing your working capital.
You can define “working capital” using fairly simple math: current assets minus current liabilities. If only its management were that straightforward — for this calculation gives rise to complex implications about the state of a business. And if you don’t keep detailed tabs on your working capital, you may fail to qualify for business financing when you need it. You could even face a cash-flow crisis should unexpected circumstances arise.
Begin managing your working capital by identifying the specific components that drive the calculation.
First, look at your current assets. The word “current” is synonymous with “short-term,” which is commonly defined as “within one year.” In other words, you use these assets to fund your daily business operations and pay ongoing expenses. Typical examples include cash, accounts receivable, inventory, marketable securities and any other liquid assets that you could readily convert to cash.
Similarly, the debt side of the equation also refers to short-term obligations, generally regarded as those due within one year. Case in point: your accounts payable. Any other accrued liabilities (such as credit lines) and debts you’ll have to pay within a year’s time also qualify (for instance, monthly principal payments on equipment financing contracts).
When managing your working capital properly, be as specific and up to date as possible with your information. Generally, you should look at three common areas that most affect working capital:
1. Receivables: Many businesses turn first to their receivables when seeking to give their working capital a boost. After all, these are accounts over which you can assert some modicum of control. This isn’t a bad idea, as you could take a carrot-and-stick approach to your accounts receivables — offering early bird discounts to new or trustworthy customers while tightening credit policies or employing in-house collections staff to “talk money in the door.”
But be careful: Using too much stick could result in a loss of customers, which would obviously do more harm than good for your working capital. So don’t rely on amped up collections alone for help. Also look to refine your collection process through measures such as electronic invoicing, requesting upfront payments from customers with questionable credit and using a bank lockbox to speed up cash deposits.
2. Inventory: Redundancies here can be crippling, because the value of such surplus items tends to plummet. This is why one of the first rules of thumb regarding working capital is to minimize inventory. Doing so reduces storage and security costs, freeing up cash, while allowing you to keep a closer, more analytical eye on what’s in stock.
Have you upgraded your inventory tracking and ordering systems recently? Newer ones can enable you to forecast demand and keep overstocking to a minimum. In appropriate cases, you can even share data with customers and suppliers to make supply and demand estimates more accurate.
3. Payables: Understandably, here the approach of many companies is the opposite of how they handle receivables. That is, they seek to delay payments to keep themselves in the best possible cash position. Yet, just as being too stringent in seeking past-due invoices can be disadvantageous, so can putting off paying the bills.
Establishing a reputation as a slow payor can lead to unfavorable payment terms in the first place and compromised credit standing. If this sounds familiar, see whether you need to rebuild your vendors’ trust. The goal is to, indeed, take advantage of deferred payments as a form of interest-free financing while still making those payments within an acceptable period.
There are likely many tweaks you could make to your business process to improve your working capital management. But to truly help ensure sustained success in this area, the initiative must start from the top. Raise the concept at strategic planning sessions and give updates on working capital status at regularly held management level meetings.
Sometimes it’s solely up to the business owner to champion the cause. But, at mid-size businesses, key players such as the controller, vice president and head of sales or production should all have a role in promoting awareness of working capital management.
In addition, companies that succeed at working capital management tend to have the IT infrastructure in place to keep themselves informed about every key data point. So look to centralize your financial transaction processing to the extent possible. If you haven’t already, consider implementing an enterprise resource planning software package to drive daily credit and collection activities to a central location.
Also think about how better technology could accelerate accounts receivable and, thereby, bolster working capital. For example, creating or upgrading a system to receive and process electronic payments from customers could improve collections for you while offering greater convenience for those outside parties.
Cash flow is indeed important. But within that flow are many currents that keep dollars moving in a positive direction. Working capital is one of these. Being able to generate and deploy liquid cash via robust current assets and managing liabilities is critical to maintaining your company’s competitive edge and keeping it in good standing with stakeholders and financing sources. Contact our team of CPAs and business advisors in Michigan, Houston or Ft. Lauderdale can help you keep cash flowing and balance working capital.
This publication is distributed for informational purposes only, with the understanding that Doeren Mayhew is not rendering legal, accounting, or other professional opinions on specific facts for matters, and, accordingly, assumes no liability whatsoever in connection with its use. Should the reader have any questions regarding any of the news articles, it is recommended that a Doeren Mayhew representative be contacted.
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