The lifeblood of your business
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The end of a year is often a time of taking stock, and these4 suggestions from a director of Williams & Glyn 's Bank may help the operator to make the best use of his working capital
-1E LIFEBLOOD of any busi;ss, whatever its size, is worng capital. Manage it effecfely, and you're on the road to ccess; mismanage it, and you ad for disaster.
In round terms, working pital represents your ability to y your way. Putting it for311y, it consists of the assets of :irculating nature employed in iur business, essentially for irrent use. These can be Pulated as follows: Arrant liabilities editors (amounts you owe to your suppliers) ink overdraft
-nount due to Inland Revenue
Arrant assets ish in hand ish in the bank (credit balances) ocks of raw materials
ock of . work-inprogress items
ocks of finished goods ;btors (amounts owed to you)
The difference between all ur current assets and your -rent liabilities is your working Pita'. You may wish to work t what the working capital of jr business is by taking the propriate figures from your t balance sheet.
The key to understanding ,rking capital is to appreciate cyclical nature and its link :h the pattern of trading. You irt your business with an iount of cash in hand — your 'n capital, perhaps, may be pplemented by loans from ur friends and from your You use some of this cash to y stocks, and these would .o appear on your balance )et. Creditors will also appear, the extent that the stocks ye not been paid for.
You then have to produce the ods you're in business to sell, d you'll either receive cash or fe credit for these. In the latter se, debtors will have been iated on your balance sheet. Eventually, they pay you. is boosts your cash balance, d you return once more to ;h at the beginning of a new le.
The length of time taken to -wen the initial cash or capital o goods and then into cash am n is the length of your worig capital cycle — and you 1st be aware of this if you are
manage your working
Di tal properly.
You should also note that the working capital cycle is much longer than the time taken for your production and sales, and one of your aims should be to reduce the length of this cycle to the minimum.
Obviously the length of the cycle varies from business to business. A taxi firm, for example, has a relatively short working capital cycle, while a firm operating process plant has a relatively extended one. One business cycle may be measured in weeks, while another's may be measured in years.
As your business expands, you will find that your cycles overlap, which will give you a smoother flow of working capital. Nevertheless, you will appreciate that at particular times you are more likely to have liquid funds than at other times; just as, occasionally, you will be subject to a shortfall.
Whatever the length of cycle that is appropriate to your kind of enterprise, the rule is always that the faster the turn-round of working capital, the greater the profitability.
The reason for this is that you have to pay for less funds, so for shorter periods your assets are used more efficiently and your turnover is greater.
Achieving the fastest possible turn-round depends on good management of your working capital. Managing your working capital effectively depends on detailed planning, in such a way that your purchasing, stocks and sales are always known; and planning in turn is finally dependent on knowing the length of your working capital cycle and the troughs and peaks that you will encounter during this cycle.
The whole purpose of planning is to ensure that your working capital is, at all times, at the right level to pay your creditors, and ensure that they do not force you into liquidation.
The amount of working capital that you will need is de
termined by several factors, and it is not possible to be dogmatic. There are certain ratios which will be useful in ascertaining your requirement, but these must be considered in the light of the conduct and state of your business.
The three ratios with which you are concerned for this purpose are: Your current ratio, ie This is a ratio which, when you have established what it should ideally be, you will want to keep constant in times of expanding sales. An increase in business must involve an increase in working capital.
You may wish to work out these ratios for your business.
Of course nothing stands still in business, and your working capital requirement will be affected by your business policies. Sales, production and cash inevitably interact, and a decision in one area will be directly reflected in the others. If you increase sales, for example, then there must either be an increase in production, or a reduction in stocks.
If you plan to increase production, there will probably be an increase in stocks of raw materials; and higher wages and operating costs should be reflected in your cash budget.
Any change in the conduct of your business will affect your working capital ratio, and you will see the consequent adjustments that need to be made if your working capital is to be kept at the right level: hence the vital need to plan each step most carefully.
The importance of planning can't be overstressed if you are' to control your business and acquire the working capital that is to be used again for further trading. Ideally, you will be working to a planned working capital budget, prepared by considering your cash: purchasing and production, and sales budgets.
Therefore, let's look in more detail at each of the three items. which make up your current assets: cash, stocks and debtors.
Cash follows the normal pattern of life, with surpluses at some times and shortages at others. There are two things that you should do. One is to smooth the pattern, and the other to reduce the amount of ready cash that you hold. The more liquid an asset is, the less profitable it is likely to be — money invested in your business or in the money market, for example, is earning more for you than cash lying idle in your tills.
To manage cash efficiently, then, we come immediately back to planning, with the need to make a cash forecast for this: purpose identifying all the cash! coming in and going out over a given period.
The cash flow forecast will show up the time lag in settlements from your debtors, together with the cost of funding them. You will probably consider it worth while to discuss the completed forecast with your bank manager, since hic facilities will play an important role in helping you to realise your plans, especially regarding temporary cash shortages.
Equally, your bank manager can be of assistance in placing in the money market cash which Is temporarily surplus to your
equirements for periods which ange from "callor overnight, o several months. This market txists equally for the smaller irm as for the giants of busiless.
Where a shortfall is expected, here are several ways of planting to meet it. It should be tome in mind that financing our working capital by long erm funds — through loans or ,hareholders' funds — is more ixpensive than short-term inancing.
Means to be considered, hen, would first include an iverdraft facility, which had leen previously agreed with the tank; trade credit, that is defering payment to your suppliers Dr as long as they are prepared 3 accept; tighter control of your lebtors, that is cutting the period of credit given; factoring,
discounting bills of exchange,
obtain advance payment of le bulk of the money owed to ou by your customers; and pasing, or hire purchase, to void spending cash resources -I order to equip your business,
There are formulae, too, to elp you measure the efficiency iith which you are balancing our cash flow. You can take our cash as a ratio of current ssets and compare this with your competitors' performances — a ratio which should be as low as conditions will justify.
You can relate sales to your average cash balance, to ascertain the number of times that the cash is being turned over. The more the average cash balance is utilised, the greater will be its productivity.
The next asset to be considered is stock.
Here, the first point to bear in mind is the very heavy cost involved in carrying and ordering stock — a fact that is not often fully realised: research has shown that it may be as high as 25 per cent of the total stock value.
This gives a clear incentive towards efficient stock control in itself, while, on a more visible level, the dangers of excessive holding of slow-moving stocks, or excessively diverse stocks, or disproportionate holding of stocks, can make themselves all too easily felt. Also the understocking of fast-moving items may lead to delivery dates not being met.
Information on stock levels and stock movements (which implies controlling the size of your inventories) is therefore another important element in your planning to turn round working capital, with the whole purpose being to keep stocks at the lowest possible level consistent with maintaining your production and sales plans.
In assessing the efficiency of your stock control, there are again useful comparisons that you can make. These involve sales against average stock value and, more relevantly, of the cost of sales against average stock. The quicker the rate of turnover of stock, obviously the greater is the profitability.
You will find it useful to maintain a record of the age of your stocks, and also to analyse the age of stock against sales in order to identify slow-moving or obsolete stocks.
There are a number of systems available to you to help you to arrive at economic stock levels. Economic ordering quantities can be calculated to keep the cost of ordering goods and holding the balance to a minimum — although this may conflict with the benefits of trade discount. Here, as always, a management decision is called for.
Also, minimum re-order levels for each stock item can be established. This is the level at which stock should be reordered, calculated to ensure that with normal stock usage and normal delivery periods new stocks will be received before the remaining stock is exhausted.
The third asset to consider is your debtors. As soon as you have supplied them, they are, of course, living off your cash until they pay you. Having established the balance between demand from your customers and the cost of extending them credit, it is important to set firm dates for the payment of your invoices, and it may also be helpful to offer incentives by way of discount, for quick payment.
However, if you are considering this, bear in mind that because the incentive has to be attractive to your customer it will be correspondingly expensive to you.
The more important your customer is to you, the less constrained he may feel to make payment when you would like it. Nevertheless, it is good planning to establish a schedule which regularly shows you the age of your debtors, and to look at this on a regular basis to see that no significant variations are taking place.
Within every firm somebody (if necessary, the proprietor) should have the responsibility for credit control — establishing references and so forth — an
credit management reviewing the age of all ou standing invoices, and chasin debts. If you prefer to delegat -the responsibility in order t devote time to other aspects your business, factoring se vices are a possibility.
If you want to use a forrnul to help you to compare yot debtor position again: your plans, you can divide yot debtors by annual sales an multiply the result by 365. Th will give the number of da credit that you are actually e: tending.
• A comparison with yot. competitors' ratios will tell yo whether this is generall acceptable for your particulz Operation.
Finally, we come to currer liabilities — yet another aspec of your working capital. Wo king capital is influenced by th amount of credit that suppliei will give you, and it is wise I take advantage of this while als bearing in mind that this is narrow path to tread.
You will normally be wel advised to take advantage ( your suppliers' discounts fc prompt payment. As we hav said, they must be pitched at a attractive rate, compared wit the cost of money to you, so may be worth while even to g to overdraft to do it.
Short-term liability alwa:y costs less than mediumc long-term credit, and the great( the proportion of your currer liabilities to your total liabilitie. the greater is the profitability ( your business. This is provide( of course, that current liabilitiE do not exceed current assets a r the other working capital ratic are maintained.
A formula which will enab you to ascertain how rnuc credit you are taking from yet suppliers is to divide your crec tors by your annual purchasf and multiply by 365. This w give you in days the exact peric of credit you are actually takini Compare this with the peric of credit you are giving to yoi customers; if the credit you a taking is longer than that whir you are giving, the more prof able your business is likely to b
Cash, stocks, debtors ar creditors make up the workir capital required in the course trading and I have suggestE ways which may help you manage this ynore efficientl. Useful as they may be, howeve these are at best techniques: tf essential requirements for gor management are sound info mation and detailed planning.