Working capital management measures the financial health of your business by determining how liquid it is. In other words, it measures how efficient your business is at collecting its debts, paying its debts and managing stock. This is determined by measuring the length of time of the working capital cycle. It is the time it takes to convert your current assets minus current liabilities into cash.
- A short working capital cycle is an indication of a healthy cash flow.
- A longer working capital cycle is an indication that your business has capital tied up of which it is not earning a return on.
So, it stands to reason a business should try to maintain a short working capital cycle by selling inventory quickly, collecting its debts from customers quickly and paying its creditors slower. Put into a formula it looks like:
Working capital cycle = inventory days + receivable days – payable days
Here we drill down a little bit into creditors.
How do creditors fit in with working capital?
Creditors refers to the suppliers that your business has committed to make payments to in the future.
The first step would be to calculate on average how many days it takes for your business to pay it suppliers:
Average trade creditors / cost of sales x 365 days
Both of the above being taken from what is stated in the accounts.
A higher number of days indicates that your business doesn’t pay suppliers early and would decrease the working capital cycle. A lower number of days would have the opposite effect.
How can you improve your working capital cycle through managing your suppliers?
Your overall goal is to retain cash in your bank account for as long as possible.
From the above we can ascertain the optimised method for paying suppliers is to hold onto the cash and pay as late as possible but not going over the payment terms stipulated by the supplier. This could have a negative effect on your business through reputation of being a late payer or perhaps charged a penalty or higher interest for late payment.
A tip on how to manage this is to input all the supplier payment terms into your accountancy software when setting your suppliers up. This will highlight what invoices are due to be paid and when whilst also avoiding any invoices being paid early. When inputting payment terms, if a supplier is offering an incentive e.g. a discount, early payment should not be definite but should be considered in terms of your cash flow.
The frequency of which you make payments may also help improve cash flows through modifying your payment process so you make only weekly or monthly payment runs.
Where possible you should try to negotiate favourable payment terms. Some suppliers have set payments terms for every customer, however there may be some where you are able to negotiate terms that are favourable to your business. For example, payment by the end of the month or payment terms that are line with when your receivables are due. Supplier relationships are important to your business and so when adopting this method, it should be dealt with without increasing the risk of damaging that relationship.
One final area that should be addressed is reviewing your administrative and accounting processes. By streamlining these you may be able to cut back on some operating costs and so improving your cashflows.
What can Invicta do for you?
Invicta Accounting is able to take on your administration and accounting processes effectively streamlining your whole process which could save you cash.
Invicta uses a cloud-based accounting software for record-keeping and reporting, which is a crucial part of managing a business’s working capital. Information is recorded accurately in our software, which you are able access at any time wherever you are in the world.
We will do the work for you through calculating various working capital ratios and analysing them to provide you with relevant information for effective decision-making relating to your business’s working capital. We can provide you with advice on the best accountancy practices on the various components of working capital, including relevant policies that suit your line of business.
Call Invicta Accounting on 01624 672358 or emails us at firstname.lastname@example.org for more information, and be sure to refer to next 3 upcoming articles for more detail on the various components as discussed above.