Generate Cash

Working capital impacts your cash flows

Working Capital has a large impact on cash within most businesses and is usually the largest investment a business will make

Most businesses focus on profit. Working capital and the cash flow impacts of decisions receive a lot less attention

One reason for this is profit is usually easier to understand and calculate. Another might be most managers are targeted for performance purposes on profit measures

Cash a critical resource within your business and as such deserves significantly more attention, reporting and analysis that it receives in most businesses


What is working capital

Working capital is the investment into your stock, WIP, debtors less your creditors

Working Capital is a vital part of managing the cash within your business and crucial for your survival and prosperity. Cash is more important than profit (in the short term). Your business can survive without profit but not without cash


So why focus on working capital?

Working Capital is usually the largest investment most businesses make yet it does not receive the attention it deserves in lots of businesses. For most services businesses (80% of UK businesses), working capital makes up the majority of the balance sheet and cash usage. Therefore, working capital does have a large impact of business valuation

Other really important operational reasons for focusing on working capital management include:

  • increasing cash balances within business (to invest in growth, pay down debt, return funds to shareholders)
  • reducing operational & financial risk (debtor non-payment, poor invoicing processes & invoicing mistakes, old stock & stock write off)
  • increasing the ability of the business to grow (lower investment requirements in working capital mean funds go further)

All of the above increase the valuation of a business as they make the business more capital efficient and less risky. Both are attractive to investors


Key Goal

The goal is to receive cash faster than it is being paid out or Creditors are greater than the sum of Stock, WIP and Debtors

Few businesses are able to achieve this i.e. have negative working capital. For businesses with positive working capital, the aim is to reduce this investment as much as is practical

There are a number of ways in which you are able to reduce your working capital investments. Some of these can be applied fairly quickly (improve credit control), others take more time (change credit terms)


Working capital impacts your business valuation

Business valuations are the present day sum of future cash flows. Changes to future cash flows will increase or decrease your business valuation.

An equity discounted cash flow (DCF) valuation might be organised as follows:

  • Future operating profits,
  • add back non-cash items (e.g. depreciation, amortisation)
  • less tax cash flows,
  • less increases in working capital,
  • less investment in CAPEX
  • add/subtract investment/funding cash flows

The sum of these cash flows are then adjusted for the time value of money at a discount rate incorporating business risk appropriate for the business.

SME/mid-cap business manager’s nearly always focus solely on increasing profit to increase valuation. Profits are an important part but only a part of the business cash flows and valuation process


What to do next

Take a look at your working capital cycle. What reporting do you currently undertake on working capital? What areas can you improve?

  • How you manage and pay your creditors
  • Stock management and stock levels including Work in Progress
  • Debtor management and credit control
  • Your invoicing process (speed and reducing errors)
  • The terms you negotiate with your clients and offer to your suppliers

Your aim is to reduce stock & debtors and increase creditors without impacting your ability to operate normally or suffer adverse issues with quality, services levels, stock availability and reputation

Who should work on this?

Improving working capital is not just a finance function responsibility. For significant sustainable improvements in working capital, the whole of your organisation needs to get involved. This starts with the management team and involves sales, procurement, supply chain, finance, and any other operational departments (depending on your business)

Incentive schemes throughout the management team should include working capital metrics. Setting up reporting and assigning targets and individual responsibilities is part of this process


If you would like help to work through options to improve your working capital:

Contact us to have a free initial discussion on how best to approach reducing your working capital

Read the next article in this series here


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