Many small businesses understand cash flow. It is easy to understand if more money is coming in than going out. However, a better judge of your business position is working capital. Working capital is the total of current assets minus current liabilities. Current assets are cash and cash equivalents (items which can quickly be turned into cash). Examples of current assets are cash in bank, accounts receivable, short-term investments and inventory. Current liabilities are obligations which are to be paid within a year. Examples of current liabilities are accounts payable, line of credit, credit cards payable and short-term portion of long-term debt.
A business wants positive working capital. This means more current assets than current liabilities. A positive amount means a company can pay its current bills. A neutral working capital amount would indicate a company only has enough current assets to pay its obligation. A negative amount of working capital means the company does not have enough current assets to pay obligations. A symptom of neutral or negative working capital is cash flow troubles. A business can avoid many cash flow issues by understanding working capital needs.
How does a business improve its working capital? You must understand financial information is inter-connected. First, you can increase working capital by increasing profits. Working capital deals with balance sheet accounts which indicate where a business's financial position is today. However, the financial drivers are from the income statement, which includes revenues, costs and expenditure accounts.
Let's assume the business cycle begins with a sale. The transaction of a sale includes: revenue increases, accounts receivable increases, costs of goods sold increase, accounts payable increase and you incur overhead expenses. The accounts receivable are collected and turned into cash. The accounts payable are paid and reduce cash. Overhead is paid and reduce cash. Remaining is your cash and profits (retained earnings).
First, review the direct drivers of your business. Can you increase sales and reduce costs? During the current economic environment it is difficult to increase sales for many businesses. These businesses feel forced in discounting in order to win the transaction. However reducing your price can have major effects on your gross profit margin (revenues less direct costs). While making a discount decision you should remember that not every sale is a victory or good business.
Second, can you reduce costs? Focus on your operation structure. How can you be more efficient with ordering, time and direct costs? You may be able to rework your production line to save costs and time. Don't be afraid of change. Think of and try new concepts. You may need to try and try again; learn from each adjustment. Remember the goal is to become more efficient and written plans usually lead to better results.
Third, reduce your overhead structure. The key to cost cutting is to reduce prices without reducing the value you receive. Negotiate with vendors for better pricing. If you do not receive your objectives receive multiple bids. Negotiate with your land lord to reduce rent (including CAM charges and not giving a personal guarantee). Be aware of moving expenses if you move locations. Review compensation packages to your employees. Be certain the compensation packages motivate employees to be their most productive.
Once you are able to increase your gross profit margin through a variety of revenue increases or costs savings and you place in a more efficient overhead structure you should have higher net profits. Higher net profits should lead to more cash and collectible accounts receivables. Be certain to leave your new profits in the company (i.e. don't take additional equity distributions or give bonuses, etc.). Your working capital should increase with your new profits.
You can also increase working capital by raising long-term debt or equity. Be aware of the consequences! Increasing long-term debt will pressure your monthly cash outflow due to loan payment obligations. Increasing equity will dilute ownership.
Now you can use the increase in working capital to strengthen your business position. First, build your current assets to at least twice the amount of your current liabilities. Second, reduce your current liabilities to manageable levels. Third, reduce long-term debt. Be mindful of tax consequences. Increasing profits will lead to an increase in income tax. However, reducing debt is not deductible. Therefore you will not want to use all of your profits to reduce debt because you will not have any monies remaining to pay tax.
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