So, why do businesses go bust because they have run out of cash even though they are making a profit? The answer is in the Working Capital Cycle.
This concept describes the time taken between the business handing money over to the supplier and the business getting it back again from the customer. Let’s go though an example:
- Day one: You call your supplier to place an order for a batch of widgets, as you are running low. You’re a small business so have to pay cash. The clock starts ticking.
- Day twenty: They deliver the widgets to you.
- Day twenty-five: Your warehouse, having run out of the last batch, starts shipping the new batch – to Customer A – who pays you on 30-day terms.
- Day fifty: The last of this batch goes out the door – to Customer B – on thirty day terms
- Day fifty-five: Customer A pays you.
- Day Eighty: Customer B pays you – stop the clock!
So, the time taken between your cash going out the door and you getting it back is between 55 and 80 days – an average of 67 days between paying and then being paid. In the meantime you’ve also had to pay your supplier in advance for the next batch, and paid your staff, and the rent, and the VAT etc.
In fact, this may be pretty good going. Many businesses source their product in China, pay cash, and then have to wait weeks for the container to be shipped to the UK. These same businesses then supply on to UK retailers – many of whom have standard payment terms of 90 days or worse. I personally know of one UK retailer who used to pay on between 120 and 150 days as standard.
If you are a growing business this can break you.
It is really important to measure, control and reduce your working capital cycle. Improve your terms with your suppliers. Hold less stock. Get better terms with your customers. Work with your bank on funding the working capital gap – there is a lot they can do to help.
Wouldn’t it be fantastic to have the perfect working capital scenario?
- You persuade all your customers to turn up and collect their own orders and pay you cash at the same time.
- You get your stock turns down to about a week or two.
- You pay your suppliers two months after they deliver.
Wouldn’t that be amazing? You’d have so much cash that you’d be wondering what to do with it. You could even make even more profit by lending it back to your customers some of whom are in financial difficulties because they had to pay you cash. But that would be far too cheeky and far fetched, wouldn’t it?
Not according to Tesco, Sainsburys etc.