By Simon Smith, Partner at Wellers
As a business owner, you should never underestimate the importance of cash flow. Although profit is a fair indication of the success of a business, even the most successful enterprises have fallen into financial difficulty because they neglected the health of their cash flow. This has been put sharply into perspective during the pandemic when hugely profitable organisations, including airlines and high street retailers, have experienced cash flow difficulties, leading them to rethink their operations.
Having a full understanding of working capital will provide you with a whole world of insights into the day-to-day running of your business and allow you to identify weaknesses to negate a cash flow crisis. But before we talk about what to do if you are experiencing cash flow difficulties, let’s first understand what working capital is.
The term working capital refers to the amount of money needed to fulfil a business’ everyday financial obligations. These are essential payments that cannot be delayed, such as staff wages and rent. If you have a negative working capital, you will not be able to make these payments.
The working capital formula will work out the short-term financial health of your business which will allow you to identify any immediate shortfalls in your finances. The calculation for this is: working capital = current assets – current liabilities.
A business with a positive working capital will have more money coming in than going out, indicating a healthy financial status. Without a positive cash flow, your business won’t be able to cover its costs which could lead to financial disaster.
In fact, cash flow issues are the leading cause of bankruptcy, so it is unsurprising that 20 per cent of start-up businesses in the UK don’t make it past their first year.
As well as working capital, you should also be aware of another key metric: the working capital ratio. This takes the theory of working capital one step further to calculate how many times your business can pay off its current liabilities by using its current assets. If the ratio is less than one, it is a clear indication that there is a financial shortfall in the business that must be addressed. The calculation for this is: working capital ratio = current assets ÷ current liabilities.
Coping with a crisis
Now we have established how to identify if you are heading for cash flow difficulty, you will be wondering what to do if you find yourself in that position. During times of financial difficulty, especially during a pandemic or other economic crisis, things may look bleak. However, there is always something you can do to improve your business’ cash flow position.
Here are four ways to do so:
Consider pivoting your business to expand your sales market into new areas. This is particularly helpful if your business cannot operate as it usually would, or you just want to expand your offering to increase sales. You could do this by extending your product lines or services, encouraging existing customers to purchase more, or by introducing referral schemes to entice new customers.
• Reassess your expenses
If you are experiencing cash flow difficulty, it may be down to spiralling costs. As well as getting more money in, you should consider minimising your outgoings. You can do this by streamlining processes, improving productivity or changing suppliers.
• Pay your bills at the right time
Even just tweaking when you pay your bills by a few days could do wonders for your cash flow. Ideally your outgoings should happen after you have received your incomings, so it would be worth negotiating invoice terms with your suppliers. Equally, if one of your suppliers offers a discount for paying early, take advantage of that if you can.
• Establish a credit control system
Establish systems and policies in your business, where relevant, that govern how much credit you extend to customers when supplying goods and services. This can also help you prevent late payment through prompt invoicing, flagging payments that need chasing, and identifying overdue bills.
You should always be aware of your cash flow position. Depending on your industry and turnover, you may want to take a temperature check monthly, or even weekly. This way you will be able to react to change from within your business, as well as external circumstances. You will also be able to factor in large payments like corporation tax and VAT.
However, if you do find yourself in a difficult situation, it is important not to panic or ignore it. Instead, work with your accountant or financial advisor to identify areas of weakness and make changes before it’s too late.