Working capital – what is it and why should I care about it? Working capital is the biggest investment most businesses make, sometimes without realising it. Don’t manage your working capital well, and your business could well fail.
If you are a business owner or business manager, or a manager within a business, the decisions you make will impact working capital.
So what is working capital? Working capital is the cash investment that you need to make before you can sell an item to make a profit.
An example of working capital
Let’s take making a smoothie as an example.
You know you can sell the smoothie, once made, for £10.
To make the smoothie, you need fruit, and a blender would also be really handy.
So before you start, you need to buy fruit. Lets say the fruit costs you £4 for each smoothie that you want to make. So at this point you have not sold anything but you have paid out at least £4.
LEARN YOUR WAY:
If you didn’t have £4, you would not be able to buy the fruit and make your first smoothie.
You will probably need to use a blender to get a good smoothie. A lower cost option might be to use a fork to mash the fruit, but rather you than me. And you might not be able to get £10 as a sale price if there are lots of big lumps in the smoothie.
Because you are busy, you hire someone to make the smoothies for you and you spend a little bit of money on electricity. You need to pay both before you can sell you smoothie.
So to make one smoothie and give yourself the chance to sell it for £10, you need £6.50 in your pocket to start with.
This £6.50 is your working capital.
Once made, you can then sell your smoothie and get back all the cash you have invested in fruit plus extra to make a profit for each smoothie sold.
You would then have £10. You could buy more fruit and make another smoothie to sell. Once this smoothie was sold, you would then have £16.50 in your pocket. Then you could afford to make two as the same time. And this would be how you might grow your business.
Earning profit and cash are NOT the same
A common error made by too many people is they assume that earning profit is the same as earning cash. Profit and cash are not the same.
There is nearly always a timing difference between when you earn profit and when you collect the cash. Everyone is taught that profit is the key thing to track, yet as every business owner knows, you can’t spend profit. You need cash to pay the wages, invest in that new product, pay for advertising, etc .
The timing differences occur because Profits are a product of accounting rules. Profits are a measurement of success and are a very important tool but they are not cash.
Cash is real. It is either in your bank account or it is not. It is that simple.
So, let’s look at why the difference between cash and profit occurs.
The below diagram shows the activities undertaken and the points at which payments and receipts happen.
Accountancy rules mean that there are significant timing differences between when profit is recognised and when you get the cash from this profit.
This difference between cash and profit is shown above with the two lines. Note that they get to the same place but have a different journey.
Again, the cash balance is negative for a long time until the customer pays which makes it positive.
The lowest negative point is the total investment you will need to make over time to make this product.
How working capital impacts growth
In nearly all businesses, the faster your growth, the more cash you need to have available to invest in growth. Or the bigger your working capital investment will be.
Going back to the smoothie example above, if you make one smoothie at a time, you will need to invest £6.50 in your business.
If you make 2 smoothies at a time, it will £13.00.
If you make 100 smoothies in one go, then your investment would be £650.00 (ignoring efficiency opportunities).
This simple example demonstrates the cash investment needed to grow a business. And there are many ways to get cash – profits, investors, bank loan and overdrafts and so on.
Assuming you have enough customers to buy your product, then how much cash you have available is usually the next limiting factor in your business growth for the reasons shown above.
Managing working capital
As working capital is likely to be one of your largest investments, it makes sense to take steps to manage this investment.
There are many ways to reduce your investment in working capital. Most of these steps aim to do one or more of these three things:
- Get customers to pay earlier
- Get suppliers to accept payments later
- And reduce the amount of product you need to keep before selling them or in accounting terms your stock or inventory.
There can be a tough balancing act between the above three aims and generating profit and growing sales. Each business choses a slightly different balance between these five areas.
Get this balance wrong and your business can fail because the business runs out of cash. For this reason, it pays to spend time managing your working capital and running cash flow forecasts to check that you have plenty of cash available to support your business plans and its growth.
More businesses fail while in growth than in decline. This shows you how important managing working capital is and why understanding how working capital impacts your business will help you personally, no matter what level within the business you work.
Negative Working Capital
There are some businesses that get paid before they have to pay anything out. This is called having negative working capital. This can be an important competitive advantage of your business.
This is how the previous example of Making a product would look with negative working capital.
As you can see, the cash is always positive. The cash also remains very different from the profit line.
Food supermarkets are great examples of businesses with negative working capital. Lets go through why quickly.
Supermarket customers pay in cash – or by card – before they leave the store. Therefore the supermarket has this cash in its bank account within a day or two of the sale. They get their customers to pay very quickly.
In addition, each supermarket keeps the amount of products in storage – their stock – to a minimum. Most of its products are on the shelves to be sold at any one point and the store take deliveries of replacement products each day. This keeps the product levels down, and their cash investment low.
Lastly, the supermarkets require their suppliers to wait quite a while to get paid i.e. they get suppliers to accept payments typically 60 days after delivery of their products to the store.
All these steps mean the supermarkets get paid cash before they have to pay out cash to run their business. This is negative working capital. All these steps mean the supermarkets get paid cash before they have to pay out cash to run their business. This is negative working capital.
Important benefits of having negative working capital is that:
- You don’t need to invest in working capital, therefore you have more cash for other things
- You can grow very quickly as the higher the growth, the more cash you get in.
It is a very nice business model to have.
Working Capital is the amount you need to invest in creating your product or service before you can sell it and get paid.
Understanding what working capital is and managing working capital are very important aspects of running a business.
Many of those businesses that haven’t paid enough attention to managing the cash impact of working capital have failed. Don’t let this be you.
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