Understanding Working Capital - Article by Alison Lemon, Director, PKF Poutsma Lemon
A recent article in the Christchurch' The Press said that 50% more businesses connected to the rebuild failed in the first 3 months of 2014 compared with the same period last year.
That's Mum and Dad businesses. But it's not just the business it's the family home, family car, boat Bach and whatever other personal assets they might have had also goes.
Most small Mum and Dad businesses generally will provide personal guarantee's to their financiers and to some creditors if they want to do business with them and that opens up their personal assets.
Another interesting observation was the same paper also reported that:
-car dealers had never sold so many expensive cars; and
-car auctioneers saying they had never had so many repossessed Utes to sell.
Perhaps I could safely surmise that there has been some business with excess cash in the Bank but no real understanding of what working capital is and how much is required.
Working capital measures a business's health. If you have working capital you can pay your bills as they fall due. And if you don't have working capital you are insolvent and can't pay your bills.
Working capital is the difference between cash assets and assets that can be turned into cash within 12 months and all liabilities that are due to be paid within 12 months. That includes any term debt that is payable within the forthcoming 12 months. It includes hire purchase payments on the Ute due to be paid in the next 12 months.
To work out if you have enough working capital the net difference should be $0 or better. A ratio of $1 of current assets to $1 of current liabilities. But business's should also look at what their gross monthly turnover is and what their terms of trade are as it maybe that a 1:1 ratio is just not enough.
The other thing that many people don't understand that as the business grows it will need more working capital. Why? Because bigger businesses generally will have bigger expenses, eg more wages, more purchases, more debtors, more overhead costs.
So it's important to understand it from the start of your business and throughout the life of your business what working capital is needed to keep the business's head above water.
Some indications and causes of working capital and business distress that I see that are:
1. Failure to pay tax or getting behind on the payments;
2. Excessive cash withdrawls by the owners;
3. Buying capital assets form working capital (the utes);
4. Large customers may "exercise muscle" by postponing payment;
5. Excessive discounting of prices.
There is a lot of good advice available to help business people manage their working capital which we also assist our clients with. These include:
- Cash Flow forecasting;
- Debtor management and terms of trade;
- Understanding your stock and dealing with stock that is not selling;
- Dealing with creditors ;
- Finance options.
In my opinion one of the primary reasons a business fails is due to a lack of working capital and poor working capital management.
So when the big cheque comes in for work you have done it doesn't mean you can go out and buy a new ute, because you may need that money the next day to pay your creditors.