Any business needs funding for many different reasons. Working capital is a type of funding that a business always needs, whether it is just starting and needs it as capital or is growing and needs it to invest in more capital.
Think of working capital as the air that any business needs to breathe. It is the lifeblood of a business. It just means the amount of money available for daily operations and how well the current assets work.
The point of a business is profitability. Most of the time, it is best to figure out how much working capital you need and how much you have regularly (every month or every three months). This way, you can make decisions based on what you have and what you need, and you can invest any extra money in a way that will give you the best return.
Working Capital management
Cash flow is a particularly important part of running a successful business. You should always have enough cash on hand, but not more than that, so you can take care of your product mix and make payments in the future.
Working capital is good because it can bring in more money for the business if properly utilized. The main problem, though, is managing this working capital. With ineffective management, a business can run into a problem called a “working capital gap.” Now, this is easier to say than to do, and it is easy to prove that we are not mismanaging money.
Let me set the record straight about the idea that mismanagement only means bad money management. It can also refer to incompetence, lack of sufficient information, or inefficiency. It is important to look out for red flags like high costs, especially for scalable startups that need money to grow. No one wants their business to run out of money, and there are many reasons why money goes where it does.
It is easier to say that you do not have enough money because you did not make enough money or because you took on a big new project. All of these are true, and this is where the funding gap comes from. And this is exactly where working capital management comes in. It is a planned process because it means you have thought about all these possible problems and made plans for them.
Working Capital fund gap
“Current assets minus current liabilities” gives you the amount of working capital. The derived number shows how much a company can pay off its current debts and still run its business well. In more advanced terms, it is also how well a company can make money from this amount. Converting this number efficiency ratio which is either extremely low or extremely high indicates a problem with funds utilization.
The funding gap is the difference between cash coming in and cash going out. That is what makes Inventory, Receivables (Inflow), and Payables different (outflow). A cash conversion metric can be a simple way to close this gap.
Operating, investing, and financing activities determine the Cash flow. The main thing we look at with this metric is “free cash flow,” which we can derive by subtracting cash from operations from cash spent on capital. Cash-flow conversion is a key indicator of how well your business is doing.
This is the process of turning your sales and profits into actual cash. It is easy to make a lot of sales, but if you are not careful, you could end up with a lot of false income and have problems with cash flow.
To understand this metric, think of the cash that is stuck in the balance sheets as accounts receivables and inventory (current assets) and unpaid cash out as accounts payables (current liabilities). Now, think of a way to get that money out of the trap and put off making payments. Instantly, you have more money.
But it does not end there. Remember you still have payables? Now, think of a way to make more money out of the money you just got so that you can pay off your bills and still have money left over.
It sounds like you have to think critically and use your efficiency ratios a lot, and you do.
Managing the working capital fund gap
To get idle funds,
1. Send invoices early so that you can get inflows faster. Automation simplifies this a lot.
2. Give customers a discount if they pay quickly. Check other metrics, like product quality and customer satisfaction, to get customers to pay faster. Money that comes in late can hurt your business. This is different from putting “pressure” on your customers to get them to leave. It is a suggestion.
3. Try to keep your inventory turnover rate as low as you can. Check your stock to see if any items do not sell well or if you have too many of them. You will save money by doing this. The company should not hold on to its stock for so long because that means it is holding on to cash unless it is to prepare for a surge in demand. A low turnover rate depends on the method of deriving the stock level, the rate of sales, and how much demand there is.
The cash conversion cycle
The cash conversion cycle gets more complicated when there are postponements in making payments. This is because delaying payments gives you more cash to use for working capital. If you do not do it right, it could also be a sign that you are unreliable or that you do not have money. The key to this is having a really good and professional sense of balance.
Another important thing to note is that two companies can have the same conversion ratio, but their liquidity can be different depending on their growth stage. This is why it is important to not only look at the numbers but also at what is driving that ratio.
As previously stated, this part of closing the working capital gap is carefully done. One of the other metrics is the cash conversion rate. But it is a simple and effective tool, especially for small businesses. If you hire a professional to manage this part of your business, it can be a key turning point for improving productivity, making more money, and growing your business.
So we have covered the effect of the working capital fund gap in more depth, with more information on why it’s relevant and how it works. Paying attention to the working capital fund gap is important for small businesses.
If you want to learn more about the working capital fund gap, contact us here for more information.