Working Capital: Why Is It So Important To Your Business?

Knowledge is key to confident financial management, says the Numbers Coach™.

Early in 2015, a company appeared on Dragons’ Den called Baggers Originals, a ‘coat in a bag’ business run by a mother and daughter team. It was a great pitch, and they successfully secured £100,000 from the Dragons. The reason for mentioning this story is that the mother had actually launched a similar business 20 years previously, had grown sales profitably to several £million, but had then run out of cash and gone bust.

So how is that possible? The business had sales and yielded profits, so why did it run into trouble? This happened because the owner wasn’t clear on one of the most important aspects of financial management:  that profit is not the same thing as cash. So while sales were growing and the business was trading profitably, there wasn’t enough actual cash in the bank to pay the bills. Not understanding that profit does not equate cash is one of the biggest reasons why businesses get into trouble. It is also comfortably the biggest cause of confusion between business owners and finance people.

So the first bit of knowledge we are going to cover is this: understanding why profit is not the same as cash in your bank.

If you were running a simple fruitseller-type business – buying on a wholesale market, selling on a street corner and chucking out unsold fruit at the end of the day – then yes the increase in cash in your pocket would be the same as profit. But as soon as you start selling on account (i.e. giving customers time to pay) – buying on account, having stock, buying equipment – then profit is no longer the same as cash in the short term. And this is the fundamental problem: your cash is in someone else’s bank account! The cash needed to finance this growth is called Working Capital.

Time for a definition: Working Capital is money tied up with your customers who haven’t paid you yet (known as debtors), plus money tied up in stock less any suppliers you haven’t paid yet (creditors). And the faster you are growing the more cash you will need to finance this working capital.

Let’s outline a small example to illustrate. Imagine for a moment that you are running a coat in a bag business and you make sales of £10,000 to a high street store. If the cost of the bags sold was £4000, then the profit is £6000. Looks good so far! But high street stores take 90-100 days to pay, your supplier is only offering you 30 days and their minimum order was £5000. At the end of the month the business will need to find £5000 cash to pay the supplier even though it recorded a profit of £6000. You then get a call from the shop saying they love the coats and want to place another order for £10,000.

I hope you can now see the really dangerous financial situation that is unfolding despite a really successful business opportunity.  As they say forewarned is forearmed, and this idea of working capital is the number one thing to be aware of. Next, let’s look at ways of managing your working capital.

If you would like to start to build your financial knowledge faster, check back to the UK2 Blog for more in my series of blog posts. 

Johnny Martin FCA is The Numbers Coach – an experienced Finance Director who now passionately explains business numbers and jargon. He is a British Library Business Centre partner where he runs regular workshops and he is a mentor for the School of Communication Arts – the world’s best advertising school. Johnny is also the author of the highly acclaimed book:  ‘Understanding Your Business Finances’   You can follow Johnny on Twitter: @numberscoach!

You can keep up to date with the Numbers Coach over on twitter or via email. Find out more about our partnership on this blog post.