Don't Close the Doors: Master Working Capital, Stay in Business

Whether your business has physical or only figurative doors to open or close, working capital – understanding what it is and how it affects your company's operations – will help you keep your doors open well into the future.

Eighty percent of new businesses fail within the first five years, a staggering fact. Many of these failures, however, could have been avoided with business owners who were well-versed in understanding working capital, cash flow, and applying the principles to their business operations.

By understanding these numbers, you will have a clear picture of the state of your company and its operations, allowing you to proactively protect what you work so hard for.

Working Capital vs. Cash Flow

Working capital is the number of liquid assets a company has on hand at any given moment. With a current balance sheet, you can easily calculate your company's working capital. To find the exact number, subtract your current liabilities (accounts payable, expenses) from your current assets (accounts receivable, cash on hand).

Working capital is the cash on hand available for the company to use to pay short-term obligations, both unexpected and planned expenses and to invest back into the business to support growth. Without enough working capital, a growing company can quickly outgrow its budget and go out of business.

Similar to working capital, cash flow is the number of liquid assets a company has on hand over a period of time. Cash flow is often displayed in a chart that allows business owners to see whether they have any cash flow gaps (moments when there is not enough working capital to cover expenses) over a monthly, yearly, or annual calendar.

These gaps vary between industries. For example, seasonal industries such as construction companies might have a cash flow gap during the winter, and snow plowing companies likely experience a gap in the summer.

Cash flow gaps might also occur in businesses that are slow to receive payment from their customers measured by Days Sales Outstanding (DSO). If customers are billed on a 60-day cycle, then there need to be two months' worth of working capital to cover the cost of goods until payment is received. Billing on a 30-day cycle drastically reduces the amount of working capital needed to maintain a business.

The CEOs Guide to Improving Cash Flow

Why Are Working Capital and Cash Flow So Important?

Working capital shows your company's cash on hand at a specific moment in time, while cash flow reveals your company's cash on hand over a period of time - weeks, months, quarters, etc.

Cash flow provides a clear picture of your business's operations over a period of time, and working capital shows your company's ability to cover immediate, perhaps unexpected expenses.

Available working capital accommodates your company's need to cover expenses such as payroll, the cost of high DSO, short-term liabilities, and unexpected expenses.

In short, if your company does not have enough working capital, you might not be able to cover necessary expenses (whether expected or unexpected) such as payroll, monthly bills, cost of goods, or expenses such as maintenance, repairs, or legal fees.

Unpaid bills lead to late fees, damaged credit ratings, your company's expenses skyrocketing, and eventually going out of business. A lack of working capital might also make it difficult to obtain bank financing or to attract investors.

How to Improve Working Capital and Solve Cash Flow Gaps

So, you have done the math and found that you might not have enough working capital to stay afloat or that your business could benefit from increasing its working capital. Consider the following changes to your business model to improve your working capital numbers.

• Minimize your DSO by getting paid faster - Optimize your billing process to limit the time between delivered services or goods and when you receive payment. Consider billing on a shorter cycle, offering 10-day payment incentives, requiring cash up front, or try milestone billing for longer projects. Getting paid more quickly will drastically reduce the amount of working capital necessary to float your business between billing cycles.
• Apply for revolving credit - Many companies fill cash flow gaps and supplement working capital with revolving credit, which can be drawn upon when necessary and paid down once payment is received. Be careful with credit, however, you will need to evaluate your company's cash flow to determine how much credit you need and when you need to pay down the obligation, rather than putting liquid cash back into your company.

Two Common Working Capital Pitfalls

1. Believing More is Better - When it comes to working capital, more is not always better. While having enough cash on hand to cover unexpected expenses will keep your business out of trouble, excessive amounts of working capital might mean you are not taking full advantage of disposable cash on hand. Sometimes excess working capital can be put to better use in the form of investments, investor payouts, and dividends, or by paying down existing debt. The sign of a healthy company is one that operates efficiently, without too much excess working capital.
2. Trying to Sell Your Way Out - Many business owners falsely believe they can solve working capital shortages by selling more. Always remember that sales do not equal increased working capital or cash flow. Although a sale increases your expected receivables, it also increases your expenses. Sales require more inventory and often increased workforce, meaning more cash spent. In addition, business owners often overlook due diligence and customer quality when making sales out of desperation. This could lead to contracts with clients who have less than stellar credit history, a potential increase in days sales outstanding, and potential losses.

Determining Your Company's Working Capital and Cash Flow

If you’d like a quick way to calculate valuable key performance indicators (KPIs) to understand how working capital and cash flow cycles affect your business, you can download our KPI Scorecard Excel Template. Simply enter values from your company's balance sheet into our KPI Scorecard to see exactly where your business's cash flow and working capital values stand.

If you find your company currently operating within a risky working capital environment, take the right steps to improve your working capital and your company's chance of staying open for the long haul.