Entrepreneurs who own seasonal businesses must manage the effects of seasonality on working capital. When most business sales occur during a certain time of year, working capital can fluctuate drastically, depending on how well working capital was managed throughout the year and how long it takes to collect accounts receivables during peak season. To ensure adequate working capital, keep a firm hand on accounts receivables during peak season and don’t overspend during slower sales cycles.
What is working capital?
Businesses have two kinds of capital: fixed and working. Fixed capital is money allocated for long-term investments, such as real estate and equipment purchases, while working capital meets the day-to-day needs of an operation including, inventory and payroll. Working capital is the difference between current assets and current liabilities. Maintaining an adequate amount of working capital is critical for all businesses but especially vital for seasonal businesses with limited opportunities for peak sales times throughout the year.
The shorter the working capital cycle, the faster the company is able to free up its cash stuck in working capital. If the working capital cycle is too long, then the capital gets locked in the operational cycle without earning any returns. Therefore, a business tries to shorten the working capital cycles to improve the short-term liquidity condition and increase their business efficiency.
The working capital cycle focuses on management of 4 key elements viz.
- Receivables (debtors)
- Payables (creditors)
- Inventory (stock)
WORKING CAPITAL CYCLE EXAMPLE
Let us assume following details for a company that is in the manufacturing sector.
- A company takes raw materials on credit and has to pay back to its creditors in few days (say 30 days in our example). This is also called as average payables period which is can be calculated as the ratio of creditors to credit purchases.
Average payable period = average creditors / credit purchases X 365.
This means that the company enjoys a credit period of 30 days on the purchase of raw materials used for the production of the final good.
- The company takes “x” number of days to sell off its inventory; the “x” here is nothing but inventory turnover ratio converted into a number of days instead of the number of times. Assuming average inventory of ₹ 5000 and average sales of ₹ 18000, the inventory turnover ratio amounts to ₹ 5000 / ₹ 18000 X 365 = 102 days approximately.
- It takes some time for the company to convert its credit sales into cash due to the credit management policy incorporated by the company in terms of the credit period extended to customers. Assuming outstanding debtors of ₹ 9000 and a total credit sale amounting to ₹ 60,000 the average collection period can be calculated as
Average collection period = average debtors/ Total Credit Sales X 365
= ₹ 9000 / ₹ 60000 X 365
= 55 days approximately
Based on the above information, we infer that
- The company has to pay back its creditors in 30 days.
- For inventory to convert to sales, it takes roughly 102 days
- Conversion of receivables (debtors) to cash, on an average, takes 55 days
The working capital cycle for the company can be calculated as given below:
Working Capital Cycle = Inventory turnover in days + debtors turnover in days– creditors turnover
= 102 + 55 -30
= 127 days
This implies that the company has its cash locked in for a period of 127 days and would need funding from some source to let the operations continue as creditors need to be paid off in 30 days.
Every company would like to keep its working capital cycle as short as possible. A shorter working capital cycle can be achieved by focusing on individual aspects of the working capital cycle.
Sources of short-term funding
Managing working capital can sometimes be a task and having enough cash on hand can be tricky. There are quite a few sources through which businesses can take up short-term funding to meet their daily working requirement.
- LINES OF CREDIT
The Company can borrow from banks for a short-term (usually 30 – 60 days) against a line of credit given by the bank. The same can be paid off once sales proceeds are collected from debtors.
- TRADE CREDIT
Often good relations with creditors can be used for extending credit period as one of the cases in case of a large order and enable financing at a lower cost.
Factoring or discounting of receivables can shorten the working capital cycle and generate cash, however, this is usually at a higher cost.
- SHORT TERM LOANS
Companies who may not be able to get a line of credit may look for the short-term working capital loan from a bank. However, you choose to raise funds to manage working capital, ensuring sufficient working capital is the key game changer for the business. Businesses not actively managing their working capital may find an exorbitant amount of financial resources being consumed in unproductive ways such as growing accounts receivable amounts and hefty inventories. Hence, choose a wise method to handle all your working capital requirements, with adequate funding.