“What are my businesses working capital needs?”


This article appears in the Nov/Dec 2014 issue of Business Franchise Australia & New Zealand

What is working capital?

Working capital in its simplest form is cash that is used in a business. It can also take the form of current assets and liabilities such as stock, debtors and creditors. These items are not cash but will be turned into cash during the trading cycle. Working capital is the lifeblood of any business.

Working capital is closely linked to the concept of cashflow. Working capital is the cash that flows through the business during the trading cycle. The trading cycle varies widely from business to business.

When assessing how much working capital is required to run a business it is critical to clearly understand the trading cycle. For a retail business the trading cycle may look like this:

1. Receive stock on credit terms (Creditors)

2. Pay wages and other expenses

3. Sell stock on credit terms (Debtors)

4. Pay Creditors

5. Collect Debtors.

In a non-retail, service or manufacturing business, stock will be replaced by work in progress (WIP). The length of time taken to complete this cycle will vary significantly from business to business. Generally speaking, the shorter the cycle the less working capital that is required.

How much working capital does a business require?

Typically a business needs enough working capital to fund one full trading cycle. That is the cash that must be expended to supply the goods or services prior to collecting the revenue from the customer. Once collected, some of these receipts will be re-invested as the working capital required to fund the next trading cycle. In this way the working capital continues to circulate through the business. It is important that some additional working capital is set aside to fund various contingencies which occur from time to time.

Where does working capital come from?

Working capital may be raised in four ways:

1. Cash invested by the proprietor

2. Money borrowed from a financier

3. Cash generated from business profits

4. Cash generated by reducing the amount of working capital required to fund the trading cycle.

Successful businesses place a high priority on the fourth method. Reducing the working capital required to fund the trading cycle will result in what is often referred to as ‘free cash’. This may be achieved by:

1. Reducing the level of stock / WIP held

2. Reducing the period of time stock / WIP is held before it is sold / invoiced

3. Collecting debtors quicker

4. Paying creditors slower.

These strategies are the easiest and most immediate ways to improve the cashflow position of any business.

Working capital (cashflow) forecasting

A working capital forecast is generally referred to as a cashflow forecast. A cashflow forecast is a component added to the end of a budget forecast. A budget is a forecast of a business’s profit position, usually completed on a monthly basis for each financial year in advance. The cashflow component uses the budget figures to estimate a bank balance at the end of each month. This is achieved by adjusting the profit for movements in debtors, creditors and capital items during the period.

It is important to understand profit is not the same as cashflow.

The main purpose of the cashflow forecast is to ensure the business has sufficient working capital to trade through the budget period. Many profitable businesses have failed due to insufficient cashflow.

Funding growth

Growth can be very difficult for a business to manage. An increase in business activity usually leads to more working capital being tied up in the trading cycle. This increase in working capital must be funded from somewhere. A key component in funding growth is the four strategies outlined above to reduce working capital required to fund the business cycle. It is often working capital that limits the speed at which a business may grow. Experience tells us that many businesses who are unable to properly manage growth fail.

Working capital is a critical component to all businesses. It must be carefully managed to ensure the business has sufficient funds to trade. A cashflow forecast should be prepared in conjunction with the budget.

Successful management of working capital will enable a business to grow and take advantage of opportunities in the future. If you have concerns in respect to managing working capital you should consult your financial advisor.

Jamie Bishop is a partner and head of the franchising division of Melbourne firm, McLean Delmo Accountants and Business Advisers. Jamie has over 14 years’ experience in public practice, specialising in business structuring, franchising, management consulting and business valuation.

McLean Delmo is a leading provider of accounting advice to franchise businesses in Australia. The team includes progressive accountants, financial planners, auditors, mortgage brokers, tax and other specialists.

Contact Jamie at:

P: 03 9018 4604
E: Jamie.Bishop@mcleandelmo.com.au
W: www.mcleandelmo.com.au