Hey …my working capital stopped working!

This post is the first of a series on managing working capital in small businesses…

All small business owners know that positive cash flow is the lifeblood of the business. Knowledge, however, does not always equate to action.  Many of the businesses we are consulting with today have issues with working capital, and they don’t always understand why.  Not all businesses have the same components of working capital, but the basic formula is similar:  the cash paid to create something vs. the cash received by selling it.   The tricky part is the timing of these events, and what we call ”working capital momentum”.

First, let’s assume that the business is getting paid more than it costs to create and sell its product and/or service (otherwise it would be an airline or auto manufacturer ~ a little humor).  That leaves the timing of the cash flows as the main issue.  When we explain the timing issue we use this basic chart:

Unless you run an all cash business, expenses are almost always paid out faster than payment for services is received. For some small businesses, the working capital shortfall (bar in red) is funded by the owners.  Most other businesses have working capital lines of credit from banks to fund the monthly shortfall.  These are often supported by a percentage of the outstanding accounts receivable.  The challenge is to manage that shortfall to a reasonable level and keep it relatively constant from month to month.  That is where momentum can play such a big role.

When a business is profitable and growing, sales are increasing which allows more availability of the line of credit. When sales are strong, companies can be more “credit selective” with their customers and avoid the slow payers.  Vendors always want business from growing customers and will often discount goods and services or offer extended payment terms.  Higher sales also generally lead to more profits which allows the line of credit to be paid down.  All this leads to increased working capital availability which can now be used to reinvest in the business and pursue even greater growth.  This business is on a roll.

Today, however, the economy has pushed a lot of businesses to the other side of that momentum swing.  Sales, and therefore accounts receivables, are decreasing.  Because of this, at the time the business needs cash the most, the line of credit availability shrinks.  Those clients that are paying, take longer. The working capital gap (red bar) begins to grow.  In response, businesses often get desperate – they cut prices and sell to customers that have shaky credit. These sales have smaller profit margins and are less likely to be collected.  As the cash dwindles, payments to vendors are delayed.  The rumors start, and customers look for alternative providers.  The cycle continues, and this business is on a downward spiral.

When we encounter businesses on the downward momentum side of working capital, we try to narrow the focus and get back to the basics: reduce the cash spend and increase the cash collected – quickly.  It’s usually the most difficult part of running a small business, and the reason so many fail in the first few years of existence. 

We’ll lay out some approaches we use – and some things to avoid - in future posts.