Whilst the UK economy bounced back from the impact of COVID-19, we now find ourselves in deeper economic waters.
In this article, we offer leaders of scaling businesses, understandably concerned about the impact of current economic conditions and changes in the complexion of the trading environment, pragmatic advice on managing cash flow and working capital to safeguard their companies.
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Contribution by Alex Hawkes.
What is the difference between cash flow and working capital?
It is important to state from the outset that the terms cash flow and working capital are not interchangeable. They show a company’s health from different perspectives.
Cash flow provides a snapshot of the liquidity of a business
The money that flows through the business; includes operating cash flow, investment cash flow (from fundraising) and cash flow from financing.
Companies must understand their sources of income and how they spend their money and have strong cash management practices in place to maintain a positive cash flow and a viable business.
Working capital compares your business’ assets and liabilities
Working capital highlights the overall operating money that a company has available after debts are removed. If a company has enough working capital, it can continue to fund its day-to-day operations and meet short-term obligations even if it experiences cash flow challenges.
One of the simplest measures of working capital is net working capital; subtract current liabilities from current assets to know if you are the positive or negative.
However, to really understand what influences working capital within your business, you need to look at the areas that impact it the most – accounts payables, accounts receivables and inventory. The following metrics will give you great insight into the working capital within your business
- Debtor days – how long it takes to collect cash from customers
- Creditor days – how long it takes to pay suppliers
- Inventory days – how quickly inventory is sold
- Cash conversion cycle – how long items are held in inventory before it is bought and paid for by the customer. Generally, the shorter the CCC, the healthier the company.
Strong working capital management practices help to insulate a business against unexpected events.
Why do you need to actively track cash flow and working capital?
Understanding and tracking cash flow and working capital is essential for businesses. You must monitor your available working capital to ensure you have enough cash to meet short-term obligations and address potential cash flow issues. In these uncertain times, a company that is not on top of its financial health can easily find itself in trouble.
How to manage cash flow and working capital?
- Recognise the cash flow’s importance and develop a cash and working capital management plan. This plan should include:
- How you plan to chase debtors.
- How you are going to implement a robust credit control system.
- How you intend to create a cash flow forecast.
- Calculations of revenue, identification of your expenses, and creation of a cash budget.
- A comprehensive review of your finances.
- Consider the supply chain in its entirety and forecast carefully over the short and medium-term to ensure a robust framework is implemented to manage supply chain risk.
- Establish a dialogue with current and new lenders and existing investors to ensure that the company’s sources of finance remain viable and appropriate given prevailing market conditions.
- Review resource and headcount requirements to evaluate whether redundancies, salary cuts or deferments are appropriate. Review resource and headcount requirements to evaluate whether redundancies, salary cuts or deferments are appropriate.
- Develop a CFO mindset across the organisation, analysing and evaluating cost structures to:
- Objectively prioritise discretionary (variable costs over which firms have a higher degree of control) and non-discretionary costs (fixed costs that firms do not have as much control over).
- Optimise working capital by deferring payments to creditors for costs that do not have an immediate cash inflow impact.
- Review capital expenditure as well as current and future investment plans by deferring, postponing, or cancelling investments.
- Consider alternative financing options with suppliers that are acceptable and appropriate to both parties, such as deferred payment, extended contract periods and postponement of contractual obligations.
What does the current inflationary period mean for cash flow and working capital?
The UK’s current inflation rate means businesses face increased costs, which will negatively impact on cash flow and working capital.
One way to mitigate against the rising costs is to shorten the cash conversion cycle.
To achieve this, CFOs must improve one of the components of the cycle, so the strategy should be to sell inventory quickly, collect revenue promptly and pay bills slowly. By ensuring you are invoicing as quickly as possible, incentivising customers to pay faster and paying bills no earlier than their due date, you stand a better chance of overcoming the financial challenges and pressure points presented by the current high inflation environment.
How can external accounting service providers help?
During challenging times, we navigate our clients through tough conditions in the following ways:
- We conduct risk assessments to determine the impact on cash as well as product and service delivery.
- We test how our client’s contingency measures are designed to deal with the direct and indirect impact of specific challenges.
- We provide detailed examinations of debtors and creditors to give our clients and their leadership teams greater visibility of any issues.
We deploy “what if?” modelling to assess the response of the business to hypothetical but entirely possible scenarios. For example, “what if new sales drop significantly?”, “what if some customers can only pay 50% of the invoices?”, “what if cash reserves begin to run dry?”, “what if 50% of staff are on sick leave?”, “what if the founder needs to fundraise at a time like this?”.
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