Understand your business cycle
Your business cycle is important, because the timing of cash movements in your business could mean you don’t have enough working capital, even if you’re profitable.
A business cycle is:
- The time it takes to manufacture a product or provide a service
- How long it takes to receive payment
- Payment finally landing in your bank account.
The longer your cycle, the more capital you’ll need while you’re waiting for payment.
Business cycle examples
Orchardists work via a seasonal cycle. They need enough cash to pay everyone to harvest and pack the fruit before they’ll see a return.
On the other hand, a hairdressing business cycles cash through daily. Payment is often immediate, with only the monthly bills to track.
Things to consider
The challenge is that no matter the length of your business cycle, fixed expenses – like wages and rent – can’t be put off. So when you’re deciding how much working capital you’ll need, it’s important to understand what kind of cycle your business runs on.
Then, decide on a rule of thumb about how much cash you need in reserve. You can work this out by determining your production and overhead costs, versus your available credit and assets.
If you can also determine how long an interruption in cash flow might be, you can calculate how much you’ll need to keep doing business over that time. Many businesses have at least three months of working capital on hand. You might need more or less.
Reduce your working capital needs
Managing your business effectively could mean increasing your working capital. But it’s also useful to identify where you can reduce your working capital needs in the first place.
Avoid personal withdrawals
Avoid numerous or large personal withdrawals. If you have spare cash, check your business doesn’t really need it first.
Think before buying major assets
Don’t buy major assets out of day-to-day operating profits if it places stress on your capital. Think about setting money aside, or explore financing options (such as leases or loans) to spread the cost over a number of years.
Be careful not to over-trade
It can sound good when a customer suddenly increases their normal order. But if you have to add on overheads, and the customer takes longer to pay, there can be real cash stress.
Reduce your inventory costs
Order effectively and only what you need. It can be tempting to order in bulk and receive a volume discount, but it eats into your cash. Sell slow-moving stock and check your annual rate of stock turn is in line with your industry average.
Make it easy for customers to pay you
Mobile payment solutions like ANZ FastPay— allow customers to pay as soon as the job’s done. Or if you still need to invoice, make sure you include your business bank account number.
Shortening the cycle
It’s important to understand the quality of your working capital. You do this by looking at the age of your debtors (how long they’ve owed you) and your payment terms with your suppliers.
Here are some things to consider:
- Collect money fast and revising your terms to a seven-day payment period can help keep your working capital healthy
- Make sure you have systems in place to deal effectively with people who owe you money, especially before you agree to extend credit in the first place
- Is it worthwhile asking if your suppliers can improve their creditor terms for you? Although it’s admirable to pay your bills fast, if it’s quicker than your customers are paying you, you’ll need more working capital.
Forecast your cash flow
Producing accurate cash flow forecasts will help you see what is happening to your working capital and take steps to improve it before you have to.
You’ll be able to predict when you need short-term finance to bridge gaps, and when you’re likely to have an increased revenue stream to invest.
Check your financial health
Use these quick test ratios to assess the current financial health of your business.
Working capital ratio
This indicates the ability of your business to meet its short-term liabilities using current or liquid assets.
To assess your working capital (or current) ratio, divide your current assets by your current liabilities.
If the answer is less than 1:1, chat to a professional for help, e.g. your business banker or accountant.
Quick asset or liquidity ratio
This tests whether your business can meet its short-term liabilities without impacting on the operation of the business.
Divide your quick assets (assets which can be converted into cash immediately, e.g. debtors) by total liabilities (liabilities which may become payable immediately, e.g. an overdraft or creditors).
A ratio of greater than 1:1 is a good indication.
Average age of debtors
This measures the effectiveness of your credit control. The shorter the average period it takes you to collect payments, the better.
Simply divide your debtors at the end of a set period by your average daily credit sales.
An answer that’s less than 60 days should be acceptable. You could also set a target of reducing your average debtor days.
Average rate of stock turn
This measures the number of times the stock turns over in your business.
It’s calculated by dividing the cost of goods sold by the average stock on hand.
If this rate is lower than your industry average, you may have more stock on hand than required.
Business performance benchmarker
Stats NZ have some useful resources to help you find out benchmarks by industry.
How to prepare your financial statements
Learn about the two main financial statements for your business: the Balance Sheet and the Profit and Loss Statement, and how to calculate some key finance ratios like profitability, business efficiency, or business liquidity ratios.
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