Feel like you need a better handle on working capital, what it is, and how you can manage it in your business? We’ve put together this guide to answer your most pressing working capital questions.
What is working capital?
Your business cannot function without capital, because it’s the money your business uses to pay your everyday business expenses. Working capital includes cash and anything that can be turned into cash in a short period of time. This article covers three types. Each has its own degree of immediate availability.
- Cash: Your company uses cash to pay its bills, buy inventory and supplies, and pay its employees. Cash on hand meets today’s expenses.
- Accounts receivable: A receivable is your customer’s unpaid bill. The receivable becomes cash once your customer settles it. Receivables are generally due within 30 – 90 days depending on your invoicing terms.
- Inventory: While you can’t use inventory to pay your immediate expenses, you could sell it at a discounted price if you needed to raise cash quickly.
1. Cash: The King
Improve your cash flow
The most basic way for a business to maximize working capital is to improve its cash flow. In simple terms, that means increasing the amount of cash coming into the business and decreasing the amount going out.
The basic formula most companies use for maintaining positive cash flow is to collect receivables quickly and slow down payables without damaging supplier relationships.
But businesses that have long invoice periods or seasonal ups and downs, often find managing cash flow to be more challenging. Here are five ways to improve cash flow that go beyond obsessive monitoring and hand wringing.
Forecast cash flow
To effectively manage cash flow, you need a really solid understanding of your income and expenses so you can create a cash flow forecast. As long as it’s business as usual, most companies are able to manage and predict what comes in and what goes out.
Challenges arise when unexpected costs start to creep into the forecast. It’s impossible to account for every unexpected cost and, depending on your industry these will vary, but you can start by making a “worst case scenario” list.
Items on your list might include replacing a critical piece of equipment, hiring additional staff, or purchasing more supplies. While you may not be able to predict the timing, knowing upfront how much the items on your list will cost can help you be more prepared.
Plus, not all costs are associated with disasters or things going wrong. Sometimes growth, new accounts, new clients, or new projects put a strain on your cash flow because they require some up front investment before you see a return. Need forecasting tips? Here’s a few from the SBA plus a free downloadable spreadsheet to get you started.
2. Receivables: Cash on Its Way
A receivables policy gets you paid on time
Every business should have an accounts receivable policy because it will help you optimize your working capital. Your policy should include when your company sends out invoices, how much it will bill, and when it will collect.
How do you develop an effective accounts receivable policy that benefits your business as well as your customers? Ensure your policy covers these four accounts receivable activities:
- Customer credit approval: clearly state how you evaluate and approve customer credit
- Collection process: include what actions will you take if you don’t get paid or an invoice is disputed
- Customer data: determine what information you should collect from customers
- Invoicing and billing: decide how and when you will let your customers know how much they owe
Collecting payments from customers
When your business gives customers the option to pay later, make sure the terms of the invoice are clear. How you manage customer payments should be part of your accounts receivable policy.
Follow these tips to optimize your customer payment processes to strengthen your working capital:
- Allow customers longer to pay. Based on your industry and other standard practices in your field, you might decide that you will allow customers to pay over time. For a customer with a small bill of sale, a simple internal scorecard might give you the information you need to determine if you’re comfortable extending their payment period. On the other hand, you may need to complete a full background and credit history check on a customer who makes large purchases on a regular basis.
- Make decisions about extending payment terms in a timely manner. Taking a long time to approve or reject an extended payment period has two negative consequences. First, it can slow down your sales process frustrating both customers and sales staff. Second and more importantly, it may result in lost sales.
- Review your payment collection processes regularly. Your customers’ growth (or lack of), industry changes, and economic changes require you to review and possibly modify your processes on a regular basis.
If you don’t effectively manage your accounts receivable, you’re not turning receivables into cash. Failure to do so can cause a trickledown effect, impacting how you pay your vendors and whether they’re willing to offer you credit. That’s why it’s so important to create and implement an effective payment collection policy. Here are some tips on how to create a smart payment and collection policy.
Managing customer data
After your business negotiates payment terms and discounts, the work is not done. You must accurately enter that information and more in your billing and collections systems. Customer data should include physical and email addresses, what and how much the customer may purchase on credit, and whether the customer receives volume discounts or advertising credits.
Here’s how you can manage your data effectively:
- Centralize data collection and management.
- Regularly audit data for accuracy and verify data that reflects unusual credit limits, payment terms, or discounts.
- Have a process for documenting and confirming changes to customer data.
- Ensure only authorized employees have the ability to change customer data.
- Make sure you have the proper policies and tools in place to protect your customers’ data security.
Mismanaging customer data can negatively impact your receivables and collection processes and therefore your working capital. If you send an invoice to the incorrect address, you won’t receive payment on time and you may assess late fees in error. If your data incorrectly sets payment terms at 60 days instead of the agreed upon 30 days, you’re slowing down the process to turn receivables into cash. If you fail to update customer credit profiles for changes such as an increased credit limits, you may put your business at risk or create a poor customer experience.
Managing invoicing and billing
Small businesses with limited staff and resources often struggle with invoicing and billing. As a result, they don’t know what payments are outstanding or they may double bill or fail to bill their customers. The former means you may lose a customer; the latter means you may not get paid for work done or product delivered.
To avoid these issues, create a billing process that generates accurate invoices that are sent to customers on a timely basis. Here are some tips for developing an effective billing process.
- Automate it. Automation can reduce time and eliminate some, if not all, human error.
- Use electronic billing systems. You can reduce delivery time by sending invoices to customers electronically. At the same time, you can offer a benefit to the customer who may be able to download your invoices into their accounting system.
- Generate exception reports. Creating and reviewing exception reports will help you identify credit and billing issues, such as balances exceeding credit limits and discount rates over the company’s credit policy.
- Offer a customer portal. Allowing customers to place orders, view their account, make payments, and initiate inquiries or disputes online will save your business time and money.
As a small business owner, you’re strapped for time. Billing and invoicing may fall to the bottom of the priority list even though it’s the first step in getting paid for your goods and services so you have working capital on hand. Ready to invest in an invoicing service? Here are 10 Online Invoicing Services for Small Business Owners.
3. Inventory and Supplies: An Overlooked Asset
Controlling inventory and supplies
Inventory and supplies take a great deal of cash to acquire, so they can have a significant impact on working capital. Managing them is a balancing act. Companies must have enough inventory and supplies on hand to meet customer demand, but not too much that cash flow is negatively affected.
To maximize your working capital, you need to adopt inventory and supply replenishment processes that best fit your business. Although processes will vary from business to business, here are best practices you should consider:
- Develop a customer fulfillment strategy. Does your company make customer deliveries on a daily basis? If so, can you make those deliveries less frequently? You may be able to reduce expenses by doing so.
- Monitor supplier performance. Create supplier scorecards to ensure your suppliers are providing you with the best materials and service. Use your scorecards as a tool to negotiate better prices or additional rebates or discounts when a supplier doesn’t perform as expected.
- Use automated and manual calculation processes. Set up your inventory system to alert you when inventory is low; however, have a person make the final decision about ordering inventory. Automated ordering may put you in an overstock situation.
- Prepare demand forecasts. It’s essential to forecast customer demand to ensure you have the right levels of inventory and supplies. Consider whether your goods and services are seasonal. Think about how quickly your customers expect to receive your goods and services. These factors and more may affect how much you have on hand at a given time.
Close management of inventory and supplies can be very helpful in your efforts to optimize working capital.
Before you can effectively control your inventory, you must have an accurate count of it. Your inventory records must be accurate. In addition, you need to adopt processes for handling variances.
Here are some tips for performing inventory counts:
- Count high-value inventory more frequently. Consider completing a full inventory count at each of your sites once a year. Identify your high-value inventory and conduct a count on it more frequently.
- Manage obsolete inventory. Your inventory counts will help you identify inventory that is moving slowly or becoming obsolete. Once identified, get rid of this inventory through sales, special deals to preferred customers, supplier returns, or scrapping it.
- Improve inventory count efficiency and accuracy. To increase efficiency and ensure the accuracy of your inventory counts, do the following:
- Provide clear instructions, including the regions to count.
- Provide pre-numbered inventory count sheets.
- Arrange products to avoid double counting.
- Develop and communicate a process to avoid counting inventory sold but not delivered.
Variances between your ledger records and physical counts are very likely. Investigate significant differences or repeated variances in the same type of inventory during your counts. Conducting regular inventory counts allows your business to be more aware of potential issues when it comes to working capital.
Putting it all together
Effectively managing your working capital is a key component of keeping your business healthy. Effective management requires an understanding of all three types of working capital, not just the total amount. That means quickly collecting on accounts receivables, controlling your inventory, and improving your cash flow forecast and management. In doing so, you will position your company to handle both growth and downturns.