Four step guide to better working capital management in micro and small enterprises

In the aftermath of the financial crisis, micro and small enterprises (MSEs) have become less reliant on, and less likely to seek, bank finance. According to European survey evidence, bank loan usage by EU micro small and medium sized enterprises (MSMEs) fell from a high of 44 percent in 2005 to 18 percent in 2016. Likewise, bank overdraft usage decreased from 50 percent in 2005 to 37 percent in 2016 (SAFE, 2005, 2016)[1]. This shift away from bank finance places even greater focus on the efficient management of working capital in businesses. Here we present a four-step guide to managing your working capital, based on a survey of practices used in MSMEs in Ireland.[2]

Working capital management is decision making on the use of short-term financing, as well as, the planning and control of working capital in a business. From an accounting perspective, it involves the management of revenues, costs and inventories. A measure of the efficiency of working capital management is the length of the cash conversion cycle, which Figure 1 illustrates.

The cash conversion cycle reflects the length of time between the start of the production process, when cash leaves a business, and the sale of the final product, when cash comes back into the business (days inventories + days receivables – days payable). The better the three elements (trade receivables, trade payables and inventories) are managed the more efficient the business is in generating cashflow.

In the example, the company takes on average 73 days from purchasing the raw materials until it sells finished goods to its customer on credit. Note, this period includes the manufacturing process as well as the length of time the finished product is sitting in stock before it is sold. Once sold, the company then waits on average a further 37 days before it collects payment from its customers. Therefore, from the receipt of the raw materials (Day 1) until the company receives payment for the sale of the finished goods takes a total of (73 + 37) 110 days, which is known as the company’s operating cycle.

Figure 1: The cash conversion cycle

Source Adapted from Brigham, E. F., and J., F. Houston (2010) Fundamentals of Financial. 12th Edition, South Western Cengage Learning.

To finance this cycle, the company receives an average of 53 days trade credit from its suppliers. The remaining gap of 57 days, which is the time between the company paying for the raw materials and then getting cash in from its customers, is known as the cash conversion period. This would likely be funded using the company’s overdraft and thus the longer the cash conversion cycle is, the more expensive it is for the company in terms of financing costs.

For owner managers ‘timing’ is critical in managing working capital. Essentially, while they are waiting for customers to pay, the business continues to operate and owners need to pay their suppliers. A gap in the timing of cash means the owner must either have an overdraft agreement in place or use alternatives sources such as personal savings and/or personal credit cards to meet the shortfall. There is a financial cost in terms of the drain on cash and a personal cost in terms of the time and stress involved in finding alternative sources.

Owner managers can use several strategies to cut the cost involved. Offering a discount to customers to pay early can be beneficial, if the cost of the discount is less than the cost of financing the shortfall while waiting to receive payment. This means knowing how much cash is in the business at any point in time and how to improve the cash position. Figure 2 presents a four-step guide for owners on the key components of working capital management and methods to improve it.

Figure 2: Four step guide to working capital management

Step 1:  Preparing a monthly cash budget

Preparing a monthly cash budget involves understanding the timing of money moving in and out of the business and helps identify when cash will be needed. In this budget, sales are recorded in the month the payment is received and not the month the sale is made. Outgoings are similarly listed in the month the money leaves the business. These could include purchases (when paid for), light and heat, internet, wages, insurance and other expenses.

The total expenses are then subtracted from the total income to give net cash flow, and the opening balance of cash is added to the net cash flow. This gives the closing cash balance, which becomes next month’s opening balance.

Processing payments in this way allows the owner manager to review the impact of changing the timing of expenses or the timing of receipt of cash and how that impacts on the overall monthly cash position.

The remaining three steps involve improving the closing cash balance.

Table 1: Example of a simple cash budget

MonthsJanuaryFebruaryMarchApril
Income€/£€/£€/£€/£
Sales Revenue10,00012,00012,00014,000
Loan5,000
Total Income15,00012,00012,00014,000
Expenses
Purchases6,0007,0007,0008,000
Drawings4,0004,0004,0004,000
Insurance500
Light and Heat300500
Total Expenses10,80011,00011,50012,000
Opening Balance04,4005,4005,900
Net Cashflow4,4001,0005002,000
Closing Balance4,4005,4005,9007,900

Step 2: Managing trade receivables inventory

Managing trade receivables is particularly important. If the owner manager gets money in from customers, she can avoid borrowing or covering any shortfall with her own money. If the business gives credit to customers, it needs to collect payment as quickly as possible. Tips to speed up this process include: issuing invoices promptly, giving a discount for early payment and following up on overdue amounts. Factoring and invoice discounting are two other options to get money in quickly based on trade receivables. Factoring works as follows.  After an invoice is issued to a customer, a copy of the invoice is sent to the financing company, which releases up to 90% of the value of the invoice. The financing company chases the payment and after payment is received it pays the balance owed to the business minus the factoring fee. Invoice discounting operates similarly, except businesses themselves chase payment not the financing company. These services incur a financial cost which needs to be weighed up against the benefit.  Previously, factoring and invoice discounting was only available to large companies but new providers such as Bibby Financial Services are making them more assessible to all businesses. Factoring and invoice discounting can provide much needed cash and while at a fee it may be worth it for the businesses in place of bank finance.

Step 3: Managing Payables

This involves managing the timing of money paid to suppliers. If an owner manager can get credit, she can use this delay in payment as a source of finance for the business and avoid external bank finance. Maintaining good relationships with suppliers will ensure this.

Step 4: Managing Inventory

This involves checking how quickly a business is turning around its inventory. If a business holds too much inventory it ties up money and in addition risks obsolescence. If it holds too little inventory it risks not being able to fulfil sales as they occur.  A balance needs to be sought. By followings steps, 2, 3, and 4, a business can rely more on internal resources and less on external bank finance.

Cash budgets – some useful apps and advice for owners

Training owner managers to understand the importance of working capital management is essential and the cash budget is a great starting point. Micro businesses have less flexibility that larger business in sourcing outside finance and need to know how to maximise the use of their own resources. Technology can help and there are apps for personal budgeting such as Money Lover and business budgeting such as Wave. As well as becoming efficient in managing working capital, owner managers need to be resourceful in examining and reducing costs.  New business owners, in particular, should consider sharing office space with complementary businesses, for example, a hairdresser and a beautician, a doctor and a dentist, an accountant and a solicitor. This cuts down on the cost of administration and secretarial services. Additional benefits include opportunities for cross referring clients and offering complementary services. Joining network groups such as Business Network International can help owners get support from other business owners, share ideas and generate business. There may of course come a time when the owner manager needs to borrow to fund working capital, in order to take advantage of growth opportunities. Nevertheless, the key message is that to reduce reliance on external funding for working capital, the owner needs to manage internal resources efficiently.

[1] SAFE (2005). SME Access to Finance [Online]. Available at:

http://ec.europa.eu/commfrontoffice/publicopinion/flash/fl174_en.pdf [accessed 12 July 2016].

SAFE (2016). Survey on the access to finance of enterprises. Available at: www.ecb.europa.eu/stats/ecb_surveys/safe/html/index.en.html [accessed 12 July 2016].

[2] Bootstrapping practice and motivations for its use in micro, small and medium enterprises, Margaret Fitzsimons, unpublished PhD thesis DCU 2018.

Dr Margaret Fitzsimons is Dean of the Institute of Banking, a qualified accountant and former small business adviser.  Dr Teresa Hogan is Senior Lecturer at Dublin City University Business School.