Business Management Articles
Making Working Capital Work Harder
Bob McMahon
Business Times
No matter what business we’re in, a struggling economy makes us all nervous. Since action helps to reduce anxiety, however, identifying ways to strengthen your working capital would be time well spent right now.
The less working capital available, the more a company needs to rely on short-term borrowing – which increases the cost of doing business. At the same time, lenders are tightening their criteria, which is affecting the availability and affordability of working capital loans and accounts receivable financing. Striving for a healthy balance of working capital should therefore be a priority during uncertain economic conditions. This is a good time to look for strains in your working capital position and to work on ways to increase and preserve it.
It’s helpful to start with some benchmarks: determine your net working capital ratio (net working capital / total assets) and your net liquidity ratio (cash + marketable securities + unused lines of credit – trade creditors / total assets). The latter takes into account the amount of credit available. The days sales outstanding ratio (receivables / annual sales / 365 days) is another helpful benchmark; it indicates the number of days required to collect payment following a sale. Reviewing these ratios on a monthly basis will alert you to any emerging working capital problems.
Once you know the current state of your working capital, look for opportunities to build and safeguard this. Are there ways to build profits? Obviously, increasing sales, for example, will increase net profit. Are there sales opportunities that you haven’t yet acted on? Can you improve sales procedures?
Eliminating unprofitable services/products is another way to enhance profits. Would doing so free company resources or time to focus on more profitable sources of revenue?
Reducing expenses is another way to increase profits. Monitor costs/sales. Consider what expenses you can reduce or eliminate without negatively impacting sales or operations. Look at both fixed and variable expenses with the view that every dollar you can reduce in unnecessary expenses is a dollar you can put to productive work in the business.
It’s also helpful to take a critical look at the company’s assets in terms of whether they are essential to the business. Is each asset generating a return on your investment? Would leasing certain assets strengthen your working capital position; for example, if you own your building, is it possible to sell it and lease it back? Or to sell equipment to a leasing company and lease it back? Or factor your receivables? If the cash generated by these transactions is used to improve or expand your business, you can build profitability and cash flow for the long term.
Restructuring debt is another way to increase working capital. With relatively inexpensive capital readily available over the past few years, many companies became over-leveraged. As profits fall, companies that are too debt-reliant can quickly fall into trouble. Watch your debt/equity ratio; ideally, it should be about 1:1 -- if it’s rising, take preventative action.
It’s also important to review your sources and forms of capital and ensure they are well suited to your type of business, your goals and needs. Consider whether some short-term debt can be converted into longer-term. Review the terms and conditions of current lending agreements and weigh opportunities to negotiate a reduction in interest or personal guarantees. It’s important not to assume that you will be able to renew existing financing arrangements when they come due. Line up alternative lenders well before you need the funds.
The quality and turnover of inventory, accounts receivable and accounts payable are also important influences on working capital. Use your inventory turnover ratio (cost of goods sold / inventory / 365) as another benchmark to monitor any changes in how frequently the company is moving goods. As well, calculate and compare the average age of payables and receivables (payables or receivables/sales x 365) to monitor the balance of cash inflows/outflows. Watch for and act on any significant changes.
It’s also important to establish a working capital contingency fund to ensure the company is not caught short of cash. Consider depositing funds every month into an interest-bearing account or securing an overdraft option with your financial institution.
If you are renegotiating loans, request 10-20% more than you need and a repayment period that is also longer than needed as a “buffer” against slowing business. And stay close to your lenders; keep them informed about the strategies you are implementing to address today’s economic challenges. The more aware and involved they are, the more likely they will be to support your business.
With turbulent conditions around the world, it’s important to be aware of changing market conditions and to implement strategies to safeguard working capital. When the economy turns around – and it will – your enterprise will be ready to act on emerging opportunities.
Bob McMahon is a partner of BDO Dunwoody LLP (www.bdo.ca). One of Canada’s leading accounting firms, BDO helps entrepreneurs and family businesses succeed. You can reach Bob in the Mississauga office at (905) 270-7700 or bmcmahon@bdo.ca.
