26 Nov 2019, 15:31 — 6 min read
Background: Working capital is the backbone of a business. It is the funds available to a company for managing daily operating expenditures and paying off short term liabilities. Working capital thus enables a business to work and continue working. Examining working capital mistakes that business owners must address.
When working capital is not properly utilised, it not only results in losses but can also derail the business in the long term. Given the current economic scenario, it has become more important than ever to closely monitor how working capital is being allocated.
The Economic Survey 2017 - 18, highlights why it is necessary to do so, especially for MSMEs. According to the survey, as of November 2017, out of the INR 26,041 billion credit extended by banks, only 17.4% was given to MSMEs. The survey listed unorganised nature of the sector, non-availability of rating from accredited associations, and inconsistent cash flow as some of the reasons why banks are not keen on lending to the one of the major contributors to the economy and employment generators in the country.
When working capital is not properly utilised, it not only results in losses but can also derail the business in the long term. It is therefore important to closely monitor how working capital is being allocated.
While no business willfully mismanages its working capital, a little oversight in day to day operations can turn into working capital management mistakes.
Here are 7 working capital mistakes that can cost you your business if not identified and corrected in time:
Not taking into consideration additional cash requirement to fund your growth and expansion plans can put a strain on your working capital. If the growth plans do not succeed or do not provide the estimated business, you can end up borrowing funds at a higher interest cost just to manage daily operations and keep the firm running.
If your business forecasting and production planning is constantly off mark, especially if you are producing more than you can sell, you end up tying your working capital in raw material and in managing and storing the excess inventory. While this is one of the most common and costly working capital mistakes, it can be kept in check by regular analyses of your sales forecast and timely corrections to it so that the procurement and production plans can be corrected as per business needs.
Also read: 5 tips for SMEs to plan a financial strategy
More often than not, businesses extend the credit period beyond their usual norm to get new business, maintain business relations or keep the account running. For example, their normal credit period might be 30 days, but to get the business, they might extend it to 45 days or 60 days. While this is not completely avoidable, making it a regular practice or extending credit to all customers can adversely affect your cash flow and thus your working capital.
Your account receivables is your main source of working capital funds. Not having a proper collection process or failing to collect dues from customers on time can put a strain on the working capital. Unfortunately, for quite a few businesses collecting accounts receivables is an Achilles heel. While it appears as an asset in the balance sheet, it can easily turn into a liability for the company in the form of loans acquired for daily operations at a higher interest cost.
It is common for businesses to ask vendors for extended credit period to tide through low cash situations. For example, your vendor gives you a credit period of 30 days, but you are not able to pay on the due date as your funds are running low. You ask for another 10 - 15 days to clear the dues. While using vendors as a source of credit is a reasonable working capital strategy, it comes at a cost. Frequent delays in vendor payments could lead to vendors losing trust in your business. This could result in delayed supplies, or vendors refusing to extend you credit.
Catering to large one-time orders requires additional funds. Apart from the investment in extra raw material, sometimes additional manpower and machinery is also required to complete the large orders. If you do not take an advance to cater to the additional expenditure, or avail of a bank loan, it has to be funded through your working capital. This can lead to a shortage of funds, as large orders may get delayed.
Apart from the payables to suppliers and vendors, companies can have other short-term liabilities in the form of loan EMIs, lease renewals, and income tax. All these expenses reduce the funds available for working capital. If these short-term liabilities are not taken into account when calculating the working capital requirements for the firm, it can create a cash shortage when the payment becomes due. Similarly, there is also a need to allocate funds for unforeseen events/contingencies. For example, rise in transport cost due to fuel price increase, labours demanding pay rise/overtime wages etc are not forecasted, but can happen. To ensure that these events do not hamper the day-to-day working, it is necessary to set aside funds for them.
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