As a result, they are more difficult to predict and are often inadequately planned and financed. It is not an exaggeration to suggest that 'Working Capital' is the lifeblood of a business (SME). Working Capital is required to pay wages, suppliers and other expenses, although payments (sales revenues) are not received from customers for days, weeks, or months following delivery of final product(s).
The working capital requirement of a business is not just its bank balance. It is also composed of its investment in stocks, debtors and creditors. Businesses have to spend money up-front on supplies to build products, and then wait for a period-of-time before payment is received from their customers. Manufacturers or distributors will have higher working capital requirements than cash businesses such as retail shops, bars or restaurants, because of the payment terms that their customers pay on. It has often been thought that because working capital can fluctuate so frequently in the short-term, it can be financed on a short-term basis. This can be one of the most common and serious mistakes a business can make. In most growing businesses, the base level of working capital required will also steadily increase. If the investment in working capital does not increase at the same rate as sales, the cash portion of the business is likely to deteriorate. If sales double, so too should the amount of working capital. Failure to plan for increasing working capital needs can lead to serious cash flow problems.
Indeed, businesses that grow too rapidly, even if they appear to be profitable, may risk business failure by overtrading without an adequate capital base. This can be avoided by following one of the three following strategies as suggested by SME Financial Systems:
1) One cure for working capital crises including overtrading is cutting back on sales; but try telling that to the people working in sales and marketing. A focus on profitable sales, rather than just on sales growth, will allow better use of the available working capital.
2) Arranging adequate longer-term financing from financiers or investors is a much more viable solution.
3) Improved working capital management involves careful timing for when you pay your suppliers and collect from your customers. Closer attention to the credit terms agreed with your customers can have a significant effect on working capital. Those who pester most usually get paid earlier.
