7 December 2020|Crisis Management, Latest Posts, Money
By Simon Smith. Profit is a fair indication of the success of a business. However, even the most profitable enterprises can fall into financial difficulty if they ignore their cash flow. This past year has put this into perspective where even hugely profitable organisations, such as airlines, tech giants and retailers, have experienced cash flow difficulties, meaning they have had to rethink their operations.
As a business owner, you mustn’t underestimate the importance of your cash flow. Having a full understanding of your working capital will provide you with a world of insights into the day-to-day running of your business that will help you identify weak points which could be a lifeline to its future survival.
What is working capital?
It’s all very well me warning you about the importance of having a healthy cash flow, but it’s valuable that you fully understand why. As some will already know, working capital is a technical term for the amount of money your business needs to fulfil its everyday financial requirements. These are essential payments that must be paid. If you have negative working capital, then you don’t have enough money to cover your costs. These costs include:
· Staff wages
· Supplier invoices
The working capital formula will measure the short-term financial health of your business, allowing you to take a temperature check and identify any immediate problem areas. The calculation for this is: working capital = current assets – current liabilities.
A healthy business will have more money coming in than going out, allowing it to take care of all its financial obligations. Without having a positive cash flow, your business won’t be able to cover its costs, which could lead to potential collapse, especially at a time when the economy is struggling.
Cash flow problems are one of the leading causes of bankruptcy, so it is no wonder that 20 percent of start-ups don’t make it past their first year in the UK and a staggering 60 percent go bust within their first three years. The importance of cash flow cannot be underestimated!
The working capital ratio
Another key metric to keep an eye on is your business’ working capital ratio. One step further than just working capital, this measure refers to the number of times a business can pay off its current liabilities by using its current assets. If your current ratio is less than one, it’s a clear red flag that you are heading for financial difficulty. The calculation for this is: working capital ratio = current assets ÷ current liabilities.
If you have done your calculations and you can see things aren’t looking as healthy as you would like them to be, then you may be asking yourself what to do now. Firstly, it’s worth remembering that there isn’t a one-size-fits-all answer to how much working capital is the right amount for a business, but it is easy to identify what isn’t enough. It’s also important to understand that as your business’ requirements will change over time, so will the amount of working capital required. This is why you should always be on top of your numbers.
During times of financial difficulty, especially during the pandemic, things may look bleak. However, there are always things you can do to improve your business’ cash flow situation. Here are three tips to improve the cash flow position of your business:
· Expand your sales market
– If it isn’t possible to operate as you currently would (perhaps due to the pandemic), or you are just looking for other ways to diversify, consider pivoting and new ways to expand your sales market. This could be by offering new products or services, encouraging customers to buy more, or introducing rewards programmes and referral schemes.
· Re-evaluate your expenses
– Overhauling your cash flow doesn’t just mean getting more money in, but also reducing the amount of money going out. You can do this by cutting out any unnecessary expenses, streamlining your business’ processes or asking suppliers for longer payment terms and discounts on bulk orders, for example.
· Pay your suppliers at the right time
– Be strategic with when you pay the bills. If your supplier offers a discount for paying early, take advantage of that. However, if a different supplier doesn’t offer a discount, keep hold of the invoice and pay when it’s most favourable to your business – without making a late payment, of course.
You may want to track your cash flow monthly, or even weekly. By keeping a regular check of this, you will always be in a good position to react to change from within your business, as well as external circumstances. You will also be able to factor in annual payments, such as corporation tax.
An accurate cash flow forecast is critical to know what is likely to happen to your working capital and is key to being able to make informed financial and investment decisions for the future of your business.
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