Finding a way to manage working capital efficiently is one of the most important tasks facing SMEs today. Here, Business Sense takes a look at the difference it can make to your company, and how you can come up with the right formula.
For many SMEs, maintaining cashflow is a huge issue. In a recent survey conducted by payments company BACS, they estimated more than a million UK SMEs were struggling with late payments, with the average amount owed being £36,000 But the other side of this coin, and one that tends to be much less remarked upon, is how late payment and poor credit control or cashflow management can affect an organisation’s ability to manage its working capital.
This, in turn, is something that can colour not only whether a firm is able to survive but, just as importantly, whether it can take advantage of new opportunities when they arise. It’s this ability that will help drive companies – and the country – out of the tough times.
Here, Business Sense looks at how taking better control of your working capital is worth prioritising.
What do we actually mean by working capital?
Working capital is closely related to cashflow – a factor that influences a company’s ability to access funds immediately – but the two terms shouldn’t be confused. Working capital is a balance sheet concept – what’s left once you subtract what you owe to others (your creditors) from what’s tied up in what you own (your stock) and what’s owed to you (your debtors).
So is it a good idea to have a lot of working capital sloshing around in your business? Yes and no. Inevitably, companies have different needs and requirements. For some it may be imperative to maintain a "buffer" to ensure creditors can always be paid on the nail or cover late payment (as above), others (perhaps those requiring large initial upfront or ongoing R&D investment) may need to operate a more debt-centred model.
"You can have very strong working capital, but if it is all tied up in unpaid debts and you do not have the cash to pay your bills that can cause a problem," concedes Philip King, chief executive of the Institute of Credit Management.
In tough times, cash flow management is imperative
Robert Downes, policy adviser at the Forum of Private Business, agrees that, in the current climate, businesses can ill afford to take their eye off the ball when it comes to cashflow management.
"Supplier payment times are getting longer too, and while this usually starts at the top of the supply chain, it washes right down to the bottom and affects the smallest firms – the ones most affected by late or slow payment," he says.
"These days, firms who don’t have good credit control are unlikely to make it past the first year of trading, it’s as simple as that," he adds.
Therefore it is important to retain a block of cash to cover "transactional demand" (paying bills or wages), "precautionary demand" (sudden one-offs or unexpected costs) and "speculative demand" (or money put aside but available for an investment or purchase), advises Clive Lewis, head of SME issues at the Institute of Chartered Accountants in England and Wales (ICAEW).
Having too much cash can also be an issue
Yet just sitting on a pile of cash can also be problematic, not least because, while it may protect your business, it doesn’t help it to grow.
Good working capital management also allows you to gauge whether you have a funding surplus or gap and, from there, what size or sort of financial facilities (such as an overdraft) you are likely to need from your bank and, crucially, what such facilities should therefore cost you.
Moreover, while maintaining positive working capital has traditionally been seen as a good idea, many big firms, especially the big supermarkets, nowadays work to a negative working capital model, points out Prof Bob Berry, Boots professor of accounting and finance at Nottingham University Business School.
"In effect they take a loan from people they have bought goods from – their suppliers – in that they say ‘we will pay you in a bit’. So they are then able to use that cash for other things and keep on moving this money around and rolling it over."
Of course, not every company will have the clout to tell its suppliers that it will pay them "in a bit", but Berry’s observation does illustrate an interesting point. There are a number of ways to manage working capital efficiently – the key, then, is not to aim for a particular paradigm, but to alight on a solution that best suits a company’s particular circumstances.
It’s all about balance
So, how can you manage your working capital more effectively? The ICAEW’s Lewis advises: "If you are managing your cashflow well you should be keeping your debtors and stock down. But if you let them grow in an uncontrolled fashion it will almost certainly create cashflow problems.
Put in place, and discuss and explain, payment terms (especially with a new customer), ensure invoices are submitted correctly, and to the right people, and that they are followed up soon after submission rather than at their due date so any problems or glitches can be sorted out early, he adds.
Who can help? Your Royal Bank of Scotland relationship manager can not only draw on a wealth of experience, but will also be able to point you in the direction of useful day-to-day management tools.
For example, Royal Bank of Scotland has developed a new online tool called the ‘Working Capital Optimiser’ designed to help you run your business as efficiently as possible. The tool can be used to identify how making small changes to your business can impact on the cash you need to run it.
Whether you want to gauge the effects of altered payment terms, work out whether your business has a funding gap or plan for longer-term growth, the Working Capital Optimiser can help plot the best course of action.