There are several different measurements that will provide you with insights into the health of your business. Profit is certainly one of them. However, even the world’s most profitable enterprises can experience financial difficulty if they ignore their cash flow.
This has never been more prevalent than during the last year when we have seen major high street retailers and even global conglomerates encounter cash flow problems, meaning they have had to pivot their businesses to avoid collapse.
Business owners should never underestimate the importance of their cash flow. In fact, poor cash flow is the leading cause of bankruptcy. So, by having a full understanding of your working capital, you can see any kinks in the chain and rectify them before they prove detrimental to your business.
To help you avoid a cash flow crisis, we asked Beth Whitmore from Wellers, one of the UK’s leading accountancy firms, to share some funding advice and tips for overcoming financial difficulty.
What is working capital?
It’s one thing being told that ignoring your cash flow could spell disaster, but it’s another thing to fully understand how. Working capital isn’t a new concept by any means and is just the technical term for the amount of money a business needs to fulfil its everyday financial requirements. If a business doesn’t have enough working capital, it will not be able to make its essential payments such as staff wages, supplier invoices, and rent.
The working capital formula will help you measure the short-term health of your business and will allow you to take a ‘temperature check’ to identify any immediate financial red flags. The calculation for this is:
working capital = current assets – current liabilities.
Healthy businesses will have more money coming in than going out. Without a positive cash flow, a business won’t be able to cover its costs, entering into a cycle of constantly playing catch up with its bills, which could eventually lead to collapse.
The working capital ratio
Another essential metric to be aware of is your business’ working capital ratio. This takes working capital one step further by assessing the number of times a business can pay off its current liabilities by using its currents assets. If a businesses ratio is less than one, it’s a clear sign that it is heading for financial difficulty. The calculation for this is:
working capital ratio = current assets ÷ current liabilities.
If you have done your calculations and you are concerned about the outcome, you may be wondering what you can do to alleviate the financial pressure before it is too late. The most important thing to remember here is that there is no one-size-fits-all approach to working capital, or a magic number you should keep to.
Every business is different, so all will have different financial needs. What’s more, this need will change over time. That is why it’s crucial you continually check your numbers.
If you do find yourself in a seemingly bleak situation, know that there is always something you can do to improve your businesses cash flow position. Here are some examples:
Broaden your business horizons
If, like many, you cannot operate your business as normal during the pandemic, or, regardless of the pandemic, the market has changed, you must find ways to pivot the business to expand your sales market. This could be by offering new products or services or introducing a referral scheme to current customers to widen your customer base.
Improve your inventory
Don’t keep hold of stock that isn’t selling. Make a list of the items that aren’t moving as quickly as other products and get rid off them as soon as possible – even if you have to offer them at a discount. Keeping hold of dead stock can tie up a lot of cash.
Pay your suppliers less
This may sound like a pipedream, but this is where maintaining friendly, regular communication with suppliers will benefit you in the long run. You may be able to negotiate a discount if you pay your invoices early. Not only does this improve your cash position, but it helps theirs too.
The frequency with which you check your cash flow will depend on the turnover of your business. You may want to check-in monthly, or even weekly. The onus is making sure you are checking it regularly. By keeping an eye on your cash position, you will always be in a good position to react to change and prevent a cash flow crisis. It will also allow you to factor in annual payments, like VAT and corporation tax.
An accurate cash flow forecast is critical to making informed financial and investment decisions for the future of your business and ensuring it does not run out of money.
This article has been written exclusively for ByteStart by Wellers Accountants. To find out more about raising finance and improving working capital, download the Wellers guide.
Last updated - 2nd February, 2021