Managing working Capital

..the key to small business success

"If you build a better mouse trap, the world will beat a path to your door."

This may just be an old saying for some, but it can be a reality for many small businessmen. Small business owners can easily be described as "supreme optimists." They often have in their heads a complete vision for their businesses and how they want it to grow. Also, they usually believe that it will be easy for the rest of the world to identify with the product or service they are offering and "beat a track to their door."

But, this is not often the case and only after the business has started to run does the owner realise the task he has ahead of him. This "supreme optimism" is usually the cause of many small business failures. Added to this, the entrepreneur may be entering a field which is new thus making it difficult to predict cost and revenue flows.

Over-estimating revenue flows or under-estimating working capital has broken many a new business, some even before they start operations, says accountant and business consultant Arthur Ghany.

Working capital comprises stocks, debtors, cash and accounts receivable. It is the amount of short term assets that would be left if all immediate debts were paid. And, the management of short term debt may be the most important area of business operations when working capital is short.

"If a business has too much working capital it is said to be over- capitalised. That is to say, it has working capital over and above its needs after taking into account the level of sales. The most common reason for over-capitalization is inefficient management of working capital.

"Small businesses hardly ever have this type of luxury, especially when they are now starting. Usually the problem they face is too little working capital.

"Even though an under capitalised business can operate at a profit, it can easily run into serious trouble if it is short of money. Inability to finance over trading will affect both the gross and net profits and eventually cause a cash flow crisis," he said.

Operating capital is mostly used up in the purchase of raw materials for production. And, efficient stock control is necessary to reduce the associated costs of over-stocking or under-stocking. The associated costs of control and management of stock tends to rise as either situations go to the extreme.

Over-stocking costs include storage, insurance, security, rental and increased administrative costs to manage the larger inventory. On the financial side, there are also interest charges on money borrowed, the loss of revenue from storing unused capital as well as the cost of not using the material or machinery of stock before it becomes obsolete.

The costs of under- stocking are delays in production from low morale among employees, a reduction in customer loyalty due to delays and the loss of revenue due to the inability to promptly fulfil customers orders.

Stock Controls

"Management of stock is not a real source of finance," Ghany adds, "but a reduction in excessive stock can reduce the need for finance and free up funds for other purposes.

"Many organizations make use of stock control models to predict optimum or ideal stock levels. The optimum level depends upon a variety of factors, including rate of turnover, demand for certain product lines, and reliability of supply. Also exchange rate fluctuation may be an additional factor in some Caribbean territories.

"A popular stock and working capital management technique used by many manufacturing firms, especially those which operate with very low working capital is Just-In-Time purchasing, made popular by Japanese auto makers."

JIT purchasing is a system in which goods ordered from suppliers are delivered by them just before they are used so that the stock level is kept as close to zero as possible. Theoretically, this system avoids the dangers of both stock-outs and over-stocking, but it demands precise planning and production forecasting.

In this regard, it works best in production lines which are quite stable and when changes are easily predictable in advance. It also requires reliable communication links.

JIT purchasing has also been one of the major sources of Japanese auto makers' cost advantage over their competitors around the world. The system works with material purchasers making their orders up to a year in advance from suppliers. Over the course of the year periodic and predictable "draw- downs" on the orders as made by the buyer. The results are bulk discounts and minimal stock holding for the buyer, and a reliable stable purchaser for the supplier. The effectiveness of this system also depends on suppliers reliability and their guarantee on the quality of goods.

Credit Management

Businesses today sell more goods on credit than they did in the past. Increase in sales and demand for credit will result in businesses needing to finance their growth and working capital. This increased need for funding results in larger overdraft and an increase in interest costs. The solution is to develop a method of credit control to avoid the cost of carrying the debtors. This should include a plan to ensure that payments are made as soon as possible and the minimization of bad debts through the maintainence of adequate records.

Ghany suggests that small firms can use the following methods to regain or maintain control of their working capital. These include reducing the credit period given to customers and offering cash discounts for prompt payments.

The effectiveness of either of these methods also depends on the particular market in which the firm operates. Reducing the credit period may result in a fall-off of customers in very competitive industries so the latter option may be more suitable, particularly if the discount can be set as a factor of the prevailing interest rate.