Having a profitable business is important but not a guarantee of success. Without enough working capital to pay for stock, premises or people, businesses can still struggle. In fact, three-quarters of SMEs seeking funding needed additional investment for exactly this reason in 2020 [1].
Poor cash flow can stifle your company’s growth. You might have an amazing idea for your website but if you can’t afford a developer, then you’re stuck. “When we look at a new opportunity, the question really isn’t whether it’s profitable, it’s how we can achieve it with our working capital,” says Alec Dobbie, CEO of online parenting club FanFinders.
One way you can manage your working capital is with the American Express® Business Gold Card, which has a payment period of up to 54 days¹. If you need to make an essential business purchase but don’t have capital available immediately, your Card can help to bridge the gap, meaning you won’t miss out on key business opportunities because of a short-term lack of working capital.
In this article, we’ll explain what working capital is and provide top tips on how to create a working capital management strategy to help your business thrive.
What is working capital management?
Working capital management is a strategy to help businesses find the right balance between their assets and liabilities, ensuring they can optimise capital to cover financial obligations and increase profit margins.
Working capital is the difference between a company’s assets and liabilities and can be calculated using this formula:
Total business assets – total business liabilities = working capital
It’s a simple calculation but not especially useful when used in isolation. What you really need is working capital management – a strategy that helps you to track, predict and understand how much working capital your business has, and what it needs to grow.
One way to begin your working capital management journey is with a cash flow map. This can be a simple diagram or spreadsheet showing how and when cash comes into – and out of – your business. Tracking this information over time helps you understand the health and liquidity of your company and predict what working capital you will need in future.
“Working capital management helps you to see where you can accelerate or optimise processes to help improve the amount of working capital,” says Jonathan Dawson, a partner in business advisory and accounting firm MKS.
A simple cash flow map could identify sources of income, such as:
- Sales
- Loans
- Profits from the business
It will also identify essential costs, such as:
- Payments to suppliers
- Costs for premises, stock and people
- Marketing and administration
Why is working capital management important?
Working capital management is a critical part of keeping your business healthy. It helps you to create a balance between growth, profitability and liquidity, by understanding:
- How much working capital is available to my business?
- Am I utilising my working capital enough, to drive business growth?
- Am I retaining enough working capital to handle the unexpected and protect my business liquidity?
Businesses that have too much working capital available might be hoarding cash that could be better used to fund new growth or innovation. Meanwhile, businesses with too little working capital might struggle to grow or even meet their day-to-day expenses.
Working capital management ratios
How do you know which of these applies to you? Your working capital ratio is how many times you could pay off your liabilities with working capital. This means if a company has £100,000 in liabilities, it should have between £120,000 and £200,000 in available working capital. In general, a working capital ratio of between 1.2 and 2.0 suggests you’ve got this balance about right.
If you sell physical products, you should also monitor how quickly your inventory is turned into sales. Inventory Turnover Ratio is the number of times a business sells and replaces inventory and is calculated by dividing the average value of stock by sales. If a retailer holds an average of £200,000 worth of stock, and makes annual sales of £1 million, then the inventory ratio is 5. A high inventory ratio (above 1) suggests strong sales (or short inventory) while a low inventory ratio (below 1) might be a warning that you are holding too much stock, or sales are declining.
Finally, working capital management should include tracking ‘debtor days’. This is the average number of days between raising an invoice and it being paid. If this figure starts to increase, it will affect future working capital, and might suggest that your business is over-exposed to customers who don’t pay on time or are experiencing cash flow problems.
Working capital management has helped FanFinders to plan for growth more effectively, says Dobbie. “We know that most of our customers are large corporates, and our industry (advertising) has a long payment cycle,” says Dobbie. “Because it can take a long time to receive payments, we use factoring to help us keep cash flow steady, and fund essential improvements to our website and platform.”
Make your business expenses work harder with Membership Rewards® points. The American Express Business Gold Card enables you to earn one Membership Rewards point for £1 spent on the Card, which can be redeemed as statement credit – allowing you to free up cash to reinvest in your business.²
4 tips for effectively managing working capital
Let’s look at some simple ways to improve your working capital management:
- Tackle late payments
- Focus on your inventory
- Forecast your cash flow
- Be proactive
Tackle late payments
One of the biggest issues for SMEs is late payments with around 40% of invoices paid late in the UK [2]. Raise invoices promptly and use software to check invoices are received and remind customers when payments are due. Consider offering discounts for early payments.
It might also be helpful to find out the average payment cycle for your industry to see how you compare. “If your competitors in the industry are being paid in 7 days while you’re being paid in 60, that suggests you can adjust your terms and still be in line with industry norms,” says Dawson.
Focus on your inventory
Use the insights provided by your inventory turnover ratio to understand your optimum stock levels and thereby optimise spending.
Forecast your cash flow
Cash flow forecasting uses past financial data to predict what working capital you’ll need in the future. You can do your own forecasting through spreadsheet templates but there are subscription-based software platforms that will link to your accounting software and use predictive analytics to forecast working capital for you. “A lot of these tools can automate key processes, making your working capital management more efficient,” says Dawson.
Be proactive
Research shows only a quarter of SMEs have recently reviewed their working capital forecasts [1], but it’s vital that this is done regularly. Stress-test your plans – what happens if a supplier goes out of business or if there’s a new competitor and sales fall by 10%?
At FanFinders, the business is actively looking to work with local companies and SMEs to reduce average debtor days, says Dobbie: “As an SME you can’t dictate payment terms to large corporate clients, but we can work towards a mixed customer profile.”
- The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
Sources
[1] British Business Bank: Small Business Finance Markets 2020/21
[2] Market Finance: UK SMEs stretched further by late payments
