Monitoring Working Capital Improves Cash Flow

A recent article by VECCI (Victorian Employer’s Chamber of Commerce and Industry) quoted ASICs figures showing that nearly 10,500 businesses entered external administration in 2011. Many were small businesses and analysts suggest the higher number of insolvencies is due to a crackdown from banks and the Australian Tax Office, which are pursuing unpaid debts and tax liabilities harder than before.

Business already pushed to the limit with overdrafts and loans are stretched as far as they can and with cash dried up, they have nowhere to go but call in the administrators.

The truth is that many business owners fail to understand or know their real Working Capital requirements and therefore expand too quickly, make bad business decisions or waste money with inefficiencies. This leads to additional requirements for cash and puts pressure on an already strained cash flow.

It’s important to understand the Working Capital requirements because understanding this figure will help understand how to improve it, and therefore keep more funds in the business.

So what is working capital? In a nutshell:

[Stock you have on the shelf +Work in Progress (labour and Parts) + Raw materials + Finished Goods] plus [Money customers owe you] minus [Money you owe your suppliers and other payables (rent etc)]
A simple way to monitor your Working Capital is to work it out as a % of Annual Sales.

For example: Let’s assume we buy 6 weeks of raw materials for production. (we buy an extra 2 weeks supply “just in case we run out”)

Assume Raw materials make up 40 % of our average sales.

1.5/12 X 40% = 5%

So for every $100 of sales we make, we need $5 to pay for the raw materials alone. Doesn’t sound like much but if we turn over $1mil that’s $50,000!. If we grow to $2mil turnover its $100,000 – suddenly that’s a significant amount of money.

Now let’s get efficient and only order exactly 1 month’s raw materials.

1.0/12 X 40% = 3.3%

So in that $1mil turnover business we now only need $33,000. That’s $17,000 we no longer need to fund buying raw materials and can be used to retire debt or for something else.

Going through the Working Capital “supply chain” we can calculate for each item as a % of sales

  • Raw Materials
  • Work In Progress
  • Finished Product
  • Receivables
  • Trade Payables
  • Other payables

Calculate the Working capital as % of sales and know that number off by heart! It’s one of the most important number’s you should know after your Gross Profit margin.

An example is shown below.

Working capital as a percent of sales

Here our Working capital is 27% as a % of sales. We now know that if we suddenly receive an order for $100,000 we need $27,000 of cash to fund that order. This number becomes meaningful because we can ask for a deposit, stage payments, stage supply or a raft of things so as not to chew up our cash.

Now if we can make some basic improvements in your Working Capital “supply chain” (as shown in red) and suddenly our business has only 18% working capital needs as a % of sales – and the business has nearly $100,000 of extra cash it no longer has to borrow.

Working Capital Supply Chain

Now that’s impressive. Of course, using an experienced Business Coach can help calculate your Working capital as % of annual sales for your business, identify any inefficiencies and help you reach your goals of achieving great Cash Flow.

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See you later.

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