Understanding Working Capital Cycle in Small Business
Every level of working capital cycle you keep has its own implications on your business.
Working capital cycle is used to illustrate the length of days it takes a business to convert its inventories into cash. If you are into manufacturing, you buy raw materials from suppliers, work on them and make it ready for customers to buy.
Customers will either buy in cash or on credit. Then you collect money back from your customers. You must understand the effect of selling on credit to customers. Generally, your aim is to minimise the length of your working capital cycle so that you can reduce your exposure to liquidity problems. The longer you hold stock, and the longer it takes you to collect cash from credit sales made to your customers, the greater cash flow difficulties you will face. Working capital cycle is illustrated graphically below:
As your company is growing, it will get to a point that the cash inflow may no longer match the cash outflow as you need more capital to meet the growing needs of your customers. At this point, it is advisable that you source for more capital in order to avoid overtrading. Overtrading is a situation whereby your business will be profitable on paper but you don’t have cash to support the level of your operation.
Why you need cash
You need cash for various purposes but the reasons for holding cash can be broadly classified into three namely transaction, precautionary and speculative purposes.
Read Also: Funding Options for Small Businesses
Transaction
You need cash for meeting day to day business requirements such as payments of office running expenses like utility bills, insurance, salaries.
Precautionary:
In business, there will be some time you will need money very urgently. That is why you need to build cash reserves which can serve as safety cushion. This type of cash is used to meet the uncertain cash requirement. You will need this cash when there is delay in payments from customers, unexpected payment request from suppliers.
The amount of cash to set aside for this purpose will largely depend on the predictability of your cash inflows and outflows and your ability to borrow funds at a very short notice. The use of cash budget can help you anticipate the likely period of cash shortage so that adequate provisions can be made in order to avoid such emergencies.
Speculative:
This is the type of extra cash needed to take advantage of temporary opportunities such as sudden price fall or unexpected opportunity to purchase assets at cheaper price
Effects of Working Capital Levels
Determining the level of working capital which is appropriate for your small business is not an easy task. But whether you have excess, adequate or insufficient working capital, every level of working capital you keep has its own implications on your small business.
Implications of adequate working capital
- You can fully exploit any sudden favourable market condition.
- Ability to pay supplier promptly ensures regular supply of raw materials.
- It helps in creating and maintaining goodwill.
- It puts you in good position to enjoy cash discount. This helps you reduce cost.
- You are not under pressure and this can help you in securing loans on easy and favourable terms.
- It helps you maintain the solvency of your small business.
- Regular payment of salaries, wages & other day-to-day commitment will enhance staff morale.
Implications of excess working capital
- It may lead to unnecessary purchasing and accumulation of inventories causing more chance of theft, waste & losses.
- It may result in overall inefficiency in the organization.
- Excessive working capital means idle funds which earn no profit for the business and hence, business cannot earn a proper rate of return on its investments.
- It can bring defective credit policy which may cause higher incidences of bad-debts.
Read Also: Working Capital Management in Small Business (Part 1)
Implications of inadequate working capital
- Inability to make bulk purchase or pay cash will deny the organization of quantity or cash discounts
- Inability to pay short term liabilities in time will result in loss of reputation. The organisation will not be able to get good credit facilities.
- It makes it difficult for the firm to exploit favourable market conditions and undertake profitable projects.
- Inability to pay salaries and other day to day expenses will create inefficiency.