(Last Updated On: March 14, 2023)
Do you have money to run daily operations in your business?
Working capital problems are prevalent in MSMEs since the dawn of demonetization and your business could fall prey to it too.
The India SME forum conducted a survey to analyze the effects of demonetization on MSMEs, two years post its implementation. The survey showed that MSMEs worked primarily on a daily cash basis, which is their working capital.
Let’s look at a more detailed understanding.
Contents
- 1 How does a lack of working capital affect small businesses?
- 2 The top 5 reasons for working capital problems
- 3 How to avoid working capital problems?
- 4 Conclusion: Remember the working capital formula
How does a lack of working capital affect small businesses?
Over 58% of MSMEs declared that demonetization was a primary cause of the retrenchment that took place at the time, owing to the inability to pay in cash. But could that have been the only reason? This is where the importance of understanding working capital comes in.
Good working capital management helps when it comes to unexpected financial decisions that could impact the business.
Sometimes, it is imperative to notice the problems you face when it comes to working capital. Some of these are:
- You cannot operate on your day-to-day activities with a lack of working capital.
- Your company loses out on market opportunities such as cash discounts and bulk lower prices on products.
- Your company could lose out on its creditworthiness as you will be unable to pay off your obligations when they have matured.
- You will lose out on excellent investment and expansion opportunities due to insufficient working capital.
- Your small business will not be able to utilize fixed assets and your assets will be depreciated in value, which will later lead to increased costs.
The top 5 reasons for working capital problems
Poor sales performance
Sales drive revenue into a business. Gross sales are one of the elements that determine a positive working capital flow into your business.
If sales are good, you can calculate working capital to see how much your business owes at the end of the year. If you have enough liquid assets to pay your bills, you are safe.
However, you know you have a problem with working capital if your sales performance is low. Less cash flow coming in results in a lack of funds to make payments later.
Past due receivables
When your past due receivables are increasing, working capital gets affected. Accounts receivables are the payments a company is yet to receive from its customers who purchased their goods or services on credit.
If a small business extends its credit line to its customers, this reduces the working capital that these businesses have for their day-to-day activities.
Tightening credit and collection policy are one of the most common methods of improving days sales outstanding (DSO).
Related read:
Poor quality of products
Customers are paying short, due to quality issues. Small businesses facing a capital crunch may not deliver on quality with their products or services, and this will result in customer dissatisfaction.
When you work with customers who are dissatisfied, they will delay payments, and demand refunds and you will wind up with a cash flow that will be unsustainable over time.
Poor inventory management
This happens when detailed information on inventory is not available and there are inventory turnover problems.
Companies need to purchase inventory on a regular basis to keep their business going. An insufficient amount of stocks can result in reduced sales and delays for customers, leading to a vicious cycle of poor cash flow into the company.
Related read:Importance of supply chain management for a successful eCommerce business
Delay in payment to vendors
When your customers fail to pay you on time, you fail to pay your vendors on time.
This results in late payment penalties and financial glitches for the vendor. This could result in a business break up and you will be on the lookout for a new vendor.
This will have an impact on your cash flow and the time lag will prolong for you to meet your working capital requirements.
How to avoid working capital problems?
Whenever there is an issue with the working capital balance, your business can try to shorten its cash conversion cycle by reconfiguring its accounts receivable, inventory management, and accounts payable practices to shift their timing and, thus, the amount of working capital on hand.
It all boils down to effective cash flow management, which basically is :
- Offering incentives to customers, like early payment discounts, to accelerate the accounts receivable receipts for example, in 10 days instead of 30.
- Expanding your inventory requires significant investment. Freeing up capital by reducing inventory can be an effective way of improving cash flow, although this is dependent on your business’s external environment also.
- Hire right! Get someone to handle your account receivables by calling customers and securing payments on time.
- Implementing a necessary timetable of inventory requirements so you need not worry about idle inventory that will become obsolete and not fetch income.
- Improvements to payments and billing procedures can work wonders for a company’s days payable outstanding (DPO) and remedy much of the long- and short-term damage in the event of a working capital problem.
Conclusion: Remember the working capital formula
Current assets – Current liabilities
Monitor your working capital. Regularly calculate your inventory turnover ratio, your customer and supplier relationship cycle, and your accounts receivable ratio. You can reduce your working capital problems simply by managing your cash flow.
A good working capital report will ensure a smooth process when you apply for a small business loan.
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