In its simplest sense, working capital means a company’s ability to pay for its dues when it comes due. This sounds super easy, but it’s actually one of the main reasons a lot of companies end up bankrupt.
For start-ups, especially, working capital concerns are key pain points for those that deal with corporates, large businesses and government entities, as it means dealing with their extended payment terms.
Managing working capital well can be helpful in at least two ways: it creates transparency in liquidity positions and it helps minimize the cost of short-term borrowings to fill the liquidity gap.
Liquidity means being able to pay for obligations as they come due. Managing a company’s liquidity position for a start-up generally means the following:
- Quickly collecting cash from sales (receivable cycle);
- Delaying payment periods for the longest possible time (payable cycle); and
- Facilitating the turnover of inventories (inventory cycle).
The above items are what finance guys would call the “cash conversion cycle.” The idea is simple, but the execution is complex.
Being able to collect cash faster is good. If you sell your products on cash or credit card bases, the cash collection cycle is already fast enough. But for others, the cash collection period can be a lot longer than the agreed term due to poor leverage, follow-through or record keeping.
To make cash collection faster, you could either shorten the payment period, follow-up more stringently or offer discounts for cash payments. Whatever the choice, there will be a cost.
Shortening payment terms and intensifying collection follow-ups may alienate customers, as they are used to their current payment plans. New customers will also compare your terms against your competitors. And, of course, large corporate customers would require much-longer payment terms as they need to manage their own working capital.
Good thing for start-ups, innovative business models can tilt the cash collection process in their favor. An example is subscription models, where customers pay in advance at the start of each month.
Delaying payments is another option for working capital management. This is doable if you are in a position to leverage. But most companies, especially start-ups, aren’t. In most cases, their customers may even implement payment in advance or upon delivery of goods or services.
But it’s not all that gloomy. For some start-ups that are good at doing “X” deals or are non-tech related, they can easily prolong payment terms if they have good negotiation skills (and a bit of charm).
From an operational perspective, managing working capital is the epitome of good financial management. Poor working capital management can result in multiple cash flow shocks, especially for bootstrapping start-ups.
While some might struggle to pay off salaries or obligations because of poor working capital management, the worst thing that may happen is going into a debt spiral. This usually results from a systemic failure to manage working capital properly, where you pay off your upcoming debt obligations by borrowing more money.
Here are a few ideas of working capital that you can do right now:
- Assess the current state of your working capital management policies. Are you maximizing your current credit terms? Are you optimizing the timing of your collections? These are some simple questions to get you started.
- Think about what can be improved in the company. It can mean accelerating the collection cycle or extending the payment schedule. There’s a lot of creative ways to improve your working capital policy—it’s not as complex as it sounds.
- Finally, plot your cash flows for your sales and purchases based on your collection and payment cycle information. This information will provide insights on when money will be flowing in and out of the company. Effectively, you’ll know when you need additional working capital and when you won’t. Through this, you can save tons through discounts and avoid interest payments.
Filbert Tsai is the chief strategy officer of continu.ee, a membership-based e-learning platform for professionals that provides quality continuing professional education courses. He is also the chief strategist at UpSmart Strategy Consulting Inc., a corporate troubleshooting firm focusing on helping struggling companies get back to its normal operations.
This column accepts contributions from accountants, especially articles that are of interest to the accountancy profession, in particular, and to the business community, in general. These can be e-mailed to boa.secretariat.@gmail.com.