It is very easy to get caught up in generating sales, but profitability is not the same as liquidity. Therefore waiting for this money to come in and being pressurised to pay for your businesses expenses, can cause cash flow strain, welcome to the working capital cycle.
The below infographic provides a snapshot summary of the working capital cycle and some formulas to help you measure how your business is performing. I also provide some options to help manage this cycle. However, it does omit the option to hold a sale, if you have too much tied up in stock and to increase prices. Increasing prices could net more cash, but it could lead to a greater default on sales and impact demand.
Like many accounting ratio's they need to be taken in context of the business and industry. So a large retailer should have a very low debtor day because they receive cash on a daily basis. A car manufacturer, on the other hand will have a much longer period before being paid by a dealer.
Within the food industry, for example, some food items such as cheese and whiskey can take years to mature and therefore can require far more investment and borrowing before cash will come in for a sale.
Formulas
The first formula is known as the current or quick ratio. Its purpose is to measure how liquid your business is. A ratio of 2:1 is seen as healthy, i.e. you have twice as much 'cash' to 'liabilities'. If you can increase this, even marginally, you can give yourself a better cushion for seasonal changes.
This ratio is also a good alert for 'over-trading'. This is when you are spending too much on production and your sales/cash receipts are not keeping up. You may have great demand, but if those customers/clients are not paying on time or you have agreed to terms that do not work for your business, you rise serious financial difficulty.
The next formula Debtors is straightforward and the figures can be taken from your Balance sheet and profit and loss statement.
I need to highlight the cost of sales element of the creditor formula. You can also use the credit purchases figure but this figure is not always that obvious to find, as your system may not be able to distinguish between your purchases that are done in retail outlets 0 days or on credit, i.e. 30-40 days to pay.
Finally inventory, this a very good metric to measure how long cash is tied up in stock. As mentioned above if you are producing food that requires several years to age, the impact of inventory can be substantial for working capital. The example assumes a business without WIP and raw materials, but the same principles apply as these are all net current asset items, so can be incorporated into the formula in the same way as inventory.
Conclusion
Managing the liquidity of your business can be hard. Making a sale is thrilling, but credit control is so important. So final tips:
1. Set payment terms that are competitive, but not unrealistic for you to pay your suppliers. Standard is from 10 to 30 days.
2. When sending invoices for the first time insist on getting a direct email address for their accounts payable team or the person paying invoices (if a small business).
3. Make sure your email mailbox is set to get receipts when emails are open/received.
4. If you do not see this email confirmation, pick up the phone to make sure they got the invoice.
5. When making a sale with a procurement manager or sales agency, try to get a Purchase Order number and put this on the invoice. The PO acts as a permission to pay.
6. Most accounting systems will provide you with debtors reports or payments outstanding reports. Reconcile these weekly.
7. For anything over your set payment terms always ring first to clear up any issues, e.g. you gave the wrong bank details or it was paid, but their reference was unclear on your bank statement.
8. If after a further 5 days payment has not been received, send a warning email with a statement of their account.
9. Day 10 over, ring again and establish the facts regarding the issues with payment.
10. Consider a payment plan or if they are in financial difficulty
11. If the amount is large enough, i.e. over £100.00, send a solicitors letter.
12. You can go to the small claims court or if the amount is large enough considering selling the debt at a discount to a company that buys debt (factoring companies etc)
13. Remember you pay taxes on income, not on cash received! So if in doubt about a future customer ask for a deposit and don't be afraid to do a credit check, or ask around other businesses in the same sector. Bad payers get a name for themselves.
