The Importance of Working Capital For Small Businesses

Most small business owners are aware of the difference between revenue and profit. You could be an ecommerce store with a million dollar turnover each month. However, if you take out the cost of procuring these products, holding them and add the cost of marketing your products, you might probably end up with just a few thousand dollars.

This is not inherently a bad thing. As long as you are measuring the performance of your business with profits and not just revenue, you are on the right track. The trouble however is that most businesses, including large corporates, fail to understand the importance of working capital. Many times, businesses fail, not because of losses, but because of their inability to manage working capital.

So what exactly is working capital? Let’s get back to the ecommerce example we talked about in the beginning of this article. Typically, a business as this buys its product from a vendor for say, $10 a piece and sells it on its store for say, $20. This way, assuming there are no holding and marketing costs involved, the profit on the item is $10. The business receives $20 from the customer and pays the vendor $10 out of this.

This appears straight-forward until you realize the trouble with payment cycles. Some vendors demand upfront payment for their products, while others offer business something like a 30 day billing cycle. So if a business were to pay upfront to the vendor in the previous example, it effectively means that they need to spend $500K each month without receiving any money from customers. A business that has enough savings in the bank to afford this can make it through to the end of the month. But if you were a business that does not have that much cash lying around, then your business is going to fail regardless of the fact that you can potentially bring one million in revenue each month.

In the example above, the $500K spare cash you will need to keep the business operational is called the working capital. With the right kind of vendor contracts, it is possible to ensure that you only pay them after you receive money from your buyers. In such cases, the working capital required to run the business smoothly is close to nil.

However, this is not entirely practical all the time. Vendors change all the time, and your business volume may be seasonal too. A healthy working capital is paramount to make sure that your business does not fall flat for the sake of a temporary non-availability of cash.

There are several ways to ensure this does not happen. The first and foremost way to do this is to definitely hire a financial consultant to restructure your agreements and analyze your cash flow. Such consultants look into your various vendor contracts and suggest ways to bring down your working capital. The second way to help with contingencies is working capital loans. There are financial institutions that specialize in working capital loans to help businesses with quick and easy access to money to overcome working capital deficits.

While working capital loans help businesses fix their cash flow problem, there are a few pointers to keep in mind though. Firstly, loans come with interest payments. If you are a business with wafer-thin margins, paying off these interests could eat into your profits. Also, some lenders charge what is called double-fees. This could be expensive if you intend to take up more than one working capital loan.

Keeping a healthy working capital is one of the oft-overlooked aspects of running a business. Bad money management here can not only make your business highly volatile and sensitive to market shocks, but can also quickly turn the fortunes of your company from a profit maker to bankruptcy.

How good is working capital management at your business? Share us your thoughts in the comments below.