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Why managing your working capital is key to a successful recovery

Understanding and reducing your cash conversion cycle will help keep your company afloat

5-minute read

Recovery from the COVID-19 shutdowns will be challenging for many entrepreneurs. Many of you will be virtually restarting your businesses from zero. Understanding your working capital needs will be critical to a full recovery.

Working capital is the money that you need to continue with day-to-day operations. In normal times, there is a continuous flow of cash coming in from receivables and payments going out to suppliers for materials and inventory. This allows you to replenish inventory on a continuous basis to support sales. But that flow stopped or slowed during the shutdowns.

Your receivables have trickled in and your accounts are mostly paid up. Client who haven’t payed you yet likely never will. Your bank balance is probably lower than usual after paying operating costs and suppliers. You may still owe money. And you probably stretched your operating line.

It’s now time to restart or scale up your operations. So how can you manage your finances to make it work?

How much working capital do I have?

The funds you have available for restarting operations can be calculated by subtracting your current liabilities from your current assets.

In the example below, the company has only $5,000 to finance its restart.

Working capital

Current assets 20,000
Cash 5,000
Accounts receivable 5,000
Inventory 10,000
Current liabilities 15,000
Line of credit 12,000
Accounts payable 3,000
Working capital 5,000

How much working capital do I need?

Step 1: Calculate your cash conversion cycle

To answer this question, you first need to consider your cash conversion cycle.

The cash conversion cycle represents the length of time (in days) that it takes for a company to convert its receivables and inventory into cash. If you carry inventory, you first receive it, you then hold it and finally release it once it is sold.

You must then wait for the customer to pay you. The inventory holding time and the collection period is the amount of time it takes to convert inventory and receivables into cash from sales.

Luckily, your vendors give you time to pay—this is “free” cash for a short time.

In the example below, the cash conversion cycle for this company is 100 days. We take the inventory holding time and cash collection time and subtract the time it takes to pay suppliers.

Cash conversion days

  Before After
Inventory holding days 75 60
Cash collection days 60 45
Supplier payment days (35) (40)
  100 65

100 days is a long time to wait for cash and you may need to close the gap. You need to pay salaries, rent and so on.

So you need to think of ways of reducing the conversion cycle, for example:

  • order inventories a little later
  • ask for customer deposits
  • issue accurate invoices immediately
  • chase collections aggressively
  • try to extend your payables

Your cash conversion cycle will dictate how much working capital you need to operate your business while you are waiting for your sales to turn into cash.

How much working capital do I need?

Step 2: Multiply cash conversion days by average sales per day

Working capital requirements can be estimated by multiplying cash conversion days by average sales per day.

A comparison of this estimate to the amount of working capital you currently appear to have on your balance sheet will tell you whether you have enough capital to fund your day-to-day expenses over the cash conversion period. If your working capital requirement estimate is higher than what you have on hand, then you will need to find a source of financing to fill the gap.

Remember, the longer your cash conversion cycle, the more working capital you will need in the form of cash and operating line.

Can I afford to restart my business aggressively?

The faster you grow, the more working capital you need. As you grow, you will spend more.

Take a hard look at the numbers and ask yourself: Do you want to restart with a bang or should you pursue more moderate and managed growth?

If you have deep pockets, you can grow aggressively. If you don’t, you will hit a brick wall because you will run out of money before your customers can pay you.

Keep a tight rein on cash flow

Finally, make sure to manage your cash flow on a continuous basis.

We have reviewed how to do this in a previous blog post, so I will not repeat the discussion.

What I do want to emphasize, at this stage is prudence:

Manage your debt

Maintain your financial health. Many of you are searching for financing to buffer your losses. If you restart and your pace does not reach pre-COVID levels, you will have trouble paying your debts and this will cause added stress.

Start saving cash

Create a cushion to buffer you through these challenging times. Remember that most experts expect a second wave in the epidemic, which will likely slow down the economy again.

As a business owner, you are responsible for maintaining the health of your employees and customers. But maintaining the financial health of your business is just as important.

Make sure you maintain cash inflows to pay your interest and debt obligations. And do not overextend yourself by acquiring too much debt or restarting your operations too aggressively.

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