Most startups face a cash flow crunch in early growth stages, even when their revenue grows, as they put working capital requirements on the back bench. While it is true that more revenue means more receivables coming your way, it also means more investment in production and inventory. If you don’t have sufficient working capital, your growth could hit a speed breaker and even put you in spiralling debt. Hence, startups need to assess their working capital requirement as they grow.

In this article, we will decode working capital for a growing business.

What Is Working Capital?

Before jumping into management, let’s get the basics right. You can calculate your working capital by subtracting Current Liabilities from Current Assets.

Current liabilities are any upcoming payment obligations in the next 12 months. It can be accounts payable (vendors, suppliers), current payment of long-term debt, any operating line of credit, and taxes or accrued expenses payable.

Working capital sees if you have the liquidity to pay these liabilities through current assets like investments, cash reserves, accounts receivables, and inventory.  

How Money Flows Through Business?

The amount of current assets and liabilities changes with business volumes. Let’s understand this with an example.

John is a garment manufacturer with an average monthly sales of 200 shirts. His current assets are $25,000, and his current liabilities are $21,000, giving him a working capital of $4,000. So far, the working capital looks strong.

There is a business change. John gets a big order for 1,000 shirts and trousers. He will have to buy the material (accounts payable), stitch, wash, iron, pack them (Inventory), deliver them to the client, and invoice them (accounts receivable). Is the $4,000 working capital enough to fulfill the new order?

Why Do You Need Working Capital?

The gap between paying the supplier, holding the inventory, and receiving the payment from the client implies the need for working capital. This gap is calculated using the cash conversion cycle formula. It states the time between buying raw materials, receiving the payment from sales, and repaying them.

If John’s cash conversion cycle is 100 days, his supplier won’t wait 100 days for their payment. This means that John must fund the accounts receivable for these 100 days from his profits. He may have to look for alternative financing options if there is inadequate profit to fund a larger order. This 100-day period will give no returns and incur an interest expense if financed through debt.

A business that fails to calculate its working capital requirement for every growth gets caught up in the debt spiral of funding its future invoices. Hence, business owners of a growing company should pay special attention to monitoring and managing the working capital to prepare for liquidity beforehand.

How to Manage Working Capital in a Growing Business?

Many businesses take the bank loan route to meet their working capital requirements. However, if clients delay the payments or cancel the order, you will be stuck with debt for longer than expected. 

Optimizing cash conversion cycle: One of the most efficient ways to meet working capital requirements in a growing business is shortening the cash conversion cycle. Instead of a 100-day cycle, John can shorten the cycle by working on the process and identifying the causes of delays.

• Accounts Receivable: You could invoice the clients immediately. If there are delays in payments, you can follow up and give them options to pay in different modes (cash, check, net banking). Open dialogue with clients can help you determine payment options and reduce your receivable days. You can also ask for advance payments in some cases, like interior design and bakery orders.
• Inventory: Sound inventory management and reducing fixed production costs can help you reduce inventory costs and increase turnover.
• Accounts Payable: You could work out a payment deadline with your suppliers, asking them for an extended deadline on higher volumes. This could give you a breather regarding working capital needs.

You can see how shorter times in any of the three processes affect the other two. Working capital management is a continuous process that can yield good results.

Funding working capital from profits: The net profit from previous orders goes towards repayment of debt, capital funding, and dividends to shareholders. If seasonal sales or higher order volumes are anticipated, you can reduce dividends and channel the earnings toward working capital. Reinvesting profits can help you avoid debt and compound your earnings. You could probably give a bonus dividend next month on achieving record sales.

Why Is It Important to Manage Working Capital In a Growing Business?

Managing working capital balances how much cash to keep idle for working capital and how much to invest in income-generating activities or business expansion to generate higher returns.

If the cash conversion cycle is shorter in a booming economy, you can aggressively invest in growth. However, if business uncertainty exists, you might want to hold more cash to fund working capital amid slow revenue.

Contact McCay Duff LLP in the Nation’s Capital to Help You Manage Working Capital

Talk to a professional accountant to help you analyze your working capital needs, optimize the cash conversion cycles, and ensure a smooth cash flow in the business. To learn more about how McCay Duff LLP can provide you with the best accounting and consulting expertise, contact us online or by telephone at 613-236-2367 or toll-free at 1-800-267-6551.