Working Capital Explained: Why It Matters and How to Improve It

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You are listening to the I Hate Numbers Podcast with Mahmood Reza. The I Hate Numbers podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now, here's your host, Mahmood Reza.

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Hi folks, and welcome to episode 52 of I Hate Numbers. That's right, you heard it right. Episode 52. That one year in, a year ago when I started the weekly podcast I Hate Numbers, my mission and aim then was to get business owners closer to their numbers to appreciate what those numbers can do, improve their money mindset, help them make more profit, save taxes, and actually give them the business that they want and deserve.

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52 weeks later, I'm still going. I'm still learning. I'm still improving. I hope I'm bringing value to you through this podcast. I hope you're enjoying and getting a bit closer to your numbers. Now, in this episode, in this anniversary episode, I've chosen the topic of working capital. Just throw in a bit of a buzzword there, and in this broadcast episode I'm going to be looking at four things.

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Number one, what on Earth do we mean by working capital? How do you work it out for your business? Why it's important and tips that you can do to improve the working capital of your business. Let's crack on with the broadcast. Now, the first thing I want you to think in terms of is visualise this. You've got a car, you've got a beautiful car.

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That beautiful car represents your business. Now, in order to operate that car, in order to get that car from A to B, you need to make sure you've got enough fuel in the tank to keep that business going. That fuel that keeps the business going is the equivalent to your working capital. Working capital is your short-term funds that are wrapped up in your business that helps you keep your business going on day-to-day, helps you pay the bills, helps you pay yourself, helps you pay your employees.

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Working capital by some people is also seen as the electricity in your house that powers and provides the energy to keep the house nice and warm and comfortable, power the cattle, the oven, and so it goes on. Now, in terms of what working capital actually is in your business, and what I want to do is to visualise two or three businesses here.

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So, if you are a service business to provide consultant services, training services, so you're not making a physical product, then you need to look at your business and consider three umbrella terms. Number one, think of those items that have value in your business, which accountants like me, call assets, and some of those assets you can break down into groupings. So, you've got some assets in your business

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which you're requiring to keep in the business to help you provide the services, so things like computers, machinery, office chair, office furniture, would all be assets in your business, but we call those fixed because they're not purchased with the intention of selling them. You maintain and keep them within your business.

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If you don't have computing equipment, if you don't have phones, office furniture and the like, it's going to be quite challenging to deliver the services. Now, the other group of assets that you might have are more short-term in nature and, effectively, the ultimate objective would be to convert those into good old-fashioned cash.

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Those short term assets, effectively, unlike the ATM in your business, they are the ones that ultimately generate the cash that you need to operate your business, to pay your supply bills, to reward yourself, to repay back loans and the like. If you check out previous podcast episodes we've had, then you'll see some great recordings on cash flow,

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but let's get back to this idea of current assets. Now, typically, most businesses, their current assets, which are just a posh way of saying short-term, are made up of three items. There are things called inventories. Now, inventories is the international term for what in the UK and other countries we might know as stock.

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So, you've got inventories and even service businesses, by the way, will have inventories. We then have got receivables, which is just a technical term for unpaid customer accounts. So, if you are selling your services, selling your products, and you give your customers time to pay their bills, then you've got receivables.

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Again, the old term is debtors. And the last item is actually good old cash, money in the bank, money that's physical in your cash tin. The third aspect is cash. All businesses will have elements of those three. So, if you're a service business, if you take on an assignment from a customer, you haven't quite finished their work, then effectively you have inventory.

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It's called work in progress. You can't physically see it, but it's there. So, as an accountant in practice, if I take on a client's assignment, a set of accounts, a bit of tax planning, if the job hasn't been completed, then that's called work in progress. If you're a training company that's offering a course spread over a period of time, then until the course is complete, then again, and you are working on that course, you've got work in progress.

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If you're a plumber or an electrician, if you start a job for a customer and the job hasn't yet been completed, then you've got work in progress. Now, if you are a manufacturer and you're making a product, so a half-completed table, a half-completed chair is also going to be called work in progress. So, all businesses will have some element of inventories.

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Does it matter? Do we need to worry about that? And the answer is yes, and I'll explain that later on in the podcast. Now, receivables are the other aspects. So, I use a customer account. Now, there are some businesses out there. Your business may be one of them that actually doesn't offer credit facilities to customers.

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If you are able to do that, sustain and grow your business, fantastic. Cash is always going to be the dictating philosophy for survival in a business, but for most of us, it's very difficult to trade. It's very difficult to expand. It's very difficult to get those customers unless there's an element of credit facilities being offered.

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Now, those are all your short-term assets. Again, we collectively call those current assets, and the idea behind the current assets aspect is that ultimately they all turn into cash. That's what we want. There's no point having a job for a customer until it's completed, and we get that money in the bank.

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Now, on the other side, there are also debts that a company has, and debts typically can be broken down into two broad categories. The first one is what's called long-term, and that's typically things like mortgages, long-term loans, higher-purchase agreements, and in the world of finance and accounting, long-term is typically anything over 12 months of duration.

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Now, the one that we are interested for today's podcast is what's called current debt. Typically, those are things like bank overdrafts, money owing to your suppliers, amounts for bills unpaid. Those are all current debts. As a P.S. by the way, in technical language, if you come across it, I don't particularly like this word.

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They use the word liabilities to effectively represent the word debt. For our purposes on today's podcast, I'm going to be using the word debt to represent that. So, now let's imagine a see-saw. On the one side of the see-saw we collect all the items that constitute current assets, and I'll suggest that you do that for your business.

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So, after this podcast, have a look around your business and toss up under these three umbrella terms, what is the money in your bank, that's the slightly easy one to calculate. Next, tot up value of your unpaid customer bills. So, all those customers that you've invoiced, how much is yet to be collected? That gives you the value of your receivables.

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The old UK terminology, and it's still used around the world, is called debtors. And the third aspect is your inventories. Now, if you are a manufacturer or a retailer, have a look around you. And if you haven't done one, do a stop check. Add up the value of all those items that you've got ready to sell to a customer.

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Have a look round. If you are manufacturing, take a view on what the value of that partly completed component or product is. Value them at the cost that you've incurred. Now, if you are a service-based business, think about the work that you've done so far. Think about what stage you are and think to yourself, okay, if I was to stop trading with my customer and build them for that proportion of work, what's the value of that work in progress going to be? Now, that goes on one side of the seesaw. Now, on the other side of the seesaw tot up what your short-term debts are.

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So, what's the level of your bank overdraft if you've got one? And bank overdrafts, by the way, are current because the banks always reserve the right to have them repaid on demand. In addition, add up how much money is outstanding to your suppliers, tot it up, and see which way the seesaw balance is. Now, ideally, you want more current assets than you've got current debts.

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A surplus is a good thing. Now, if it's negative, it doesn't necessarily mean that's the end of the road, but we are going typically for a positive working capital. Now, one more factor is taken into account. Within that group of current assets, there is one particular item that is considered very difficult or challenging to convert into cash very quickly.

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So, if our suppliers knocked on our door and says, Mahmood, you've got some outstanding bills, can you settle them up? Well, I checked to see if there's any money in the bank. If there's no money in the bank. Options are: I have a look at what's not been paid to me yet to my customer accounts, or if they're not overdue, or I'm having challenges collecting them, then where else do I go?

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Well, inventories is considered the one that's most difficult to convert into cash. If you've partially completed the service for a customer, can you get the value for that? Obviously, having payment terms where you are paid by installments is a good tip to take away. If you've got physical stock building up,

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then again, that may be quite difficult to shift at short notice. So, what we want to make sure is that we don't have a disproportionate amount of inventories building up in our business. So, let's remind ourselves where we are. We've talked about what working capital is, and it's effectively a see-saw between current assets, which are the short term things like inventory,

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receivables in cash, and the other side is the short term debt like overdrafts and unpaid supplier bills. The next thing is, why is it important? Well, if you don't have sufficient working capital, your business will not be able to operate. When it comes time to pay loans, when it comes time to pay suppliers, when it comes time to pay yourself, if you don't have sufficient liquid funds i.e cash to do those things, your business will suffer dramatically.

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So, we need a good supply of working capital to operate on a daily basis. We've talked about the elements that make up working capital. Now, let's focus in terms of now are some takeaway tips in addition to what we've discussed already. Now, when it comes to inventories, there's always a balancing effect.

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We don't want to have too much inventory building up, because that's money tied up in that asset, and if we need to get the cash from that, that might be quite problematic. If you're a service based business, then revisit the value of your work in progress, how much the work is not done, and perhaps it's a discussion you need to have with yourself or your advisors to how you can reduce the time it takes to get it delivered to the end customers, so you can build them.

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Remember, customers typically are not interested until the work is finally completed. Can you do stage payments? Are there things in your process that you can do that cuts down the time it takes to complete a job? The other aspects, such as receivables. Now, we have, typically, in all businesses to offer credit facilities to customers to get trade, and there is a cost, but there's always a cost to everything.

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The cost will be the cost of collecting that money, the cost of maintaining that customer and account, the bad debts that may unfortunately arise, the money that's tied up in those receivables. So, anything that has a relation to cost. The downside is, if you don't offer credit facilities, you may not be able to get that customer's trade.

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So, we need to think about a good credit control policy. We need to think about the terms and conditions. We need to have good capture systems like Xero to be able to operate effectively. We need to be on top of it, and we need to monitor and manage that element as well. So, from the selection and credit worthiness of the customers that we engage with the terms, if we can get deposits out front,

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if we are on top of that credit control, then that's certainly going to inject a great deal of cash back into the business. So, folks, let's just summarise where we are. We've talked about working capital, and a profitable business, by the way, doesn't actually mean it's going to survive. If your working capital is quite poor, you've got lots of money tied up in those inventories and customer accounts, then that could be quite dangerous.

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We've talked about how to calculate it. If you check out the show notes at the end, the show notes have got a worked example of working capital for two businesses, for a service business and a manufacturing business, so you can see what's going on. Now, I hope you enjoyed episode 52. I hope there are bits there you can take and apply to your business and improve it, and we should always be looking at to do what we can to improve that operating cycle, working capital cycle in our business.

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If you need any more help, check out the show notes, check out our resources, and by all means, give us a shout if you need help improving the working capital in your business. So, folks, have a great week. I'll see you next week. We hope you enjoyed this episode and appreciate you taking the time to listen to the show.

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We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.