The writer points out to different problems arising from bad management of working capital; and provides suggestions to get around this problem
Money is the lifeblood of any business. Term loans are availed occasionally. However, working capital is relevant 365 days a year, for life. I had the good fortune of observing multiple types of businesses over 37 years of my Chartered Accountancy practice and during 10 years of my stint at EDC as Chairman/Vice Chairman and Director. Based on this, I can say that working capital does not get the necessary attention from businesspersons as deserved. Huge debtors, piled up stocks plague many businesses. These two choke up businesses and some even perish! Working capital components considered below are chiefly inventories (stocks), debtors, advances, temporary deposits, etc.
Problems created by bad working capital management:
- Huge Stocks creates problems as follows: Block space, more possibility of spoilage/obsolescence / fire / pilferage, cooling equipment and power cost – all these may result in reckless use of materials, more staff to monitor stocks, security, more interest and insurance costs, squeeze on liquidity, higher cost of stock management/control. Higher the stocks of finished goods, you are forced to sell at a discount, etc.
- High Debtors: Cost of interest, older the debtors more the possibility of bad debts, banks do not finance old debtors, which results in pressure on liquidity.
- Drop in Efficiency: Less working capital means less money to pay to staff resulting in low morale; less money to pay creditors (who may prefer not to sell you more or may charge interest) neglect of upkeep and maintenance of premises resulting in despondency.
35 years back a Delhi industrialist told me that merely a glance at the premises of a business could reveal if the business is in profit. Well-maintained premises are generally in profit and vice versa. Further, poorly maintained equipment and ill paid staff will increase cost and decrease quality, resulting in loss of business and aggravate problems of working capital. It becomes a vicious cycle. A small businessperson, upon facing working capital problems tries to do many things by himself, thereby reducing his quality and competitiveness.
- Interest: The biggest problem, of course, is the 8th wonder of the world, which is interest! The interest clock does not pause on a Sunday or at night. Huge stocks and debtors have escalated interest cost and hastened the eventual collapse of many businesses.
Suggestion on working capital management:
1.1 Study carefully and cut down stocks to a minimum level say 1 or 2 months of annual requirement (stocks of raw materials, consumables, packing, maintenance, etc.) Work on your procurement logistics.
1.2 Work-in-progress/process can be minimised by innovative production efficiencies. I am witness to a doubling of production in Goa, by a big manufacturing company, merely by shifting from batch production to line production.
1.3 Finished goods stocks: Anticipating demand, soliciting advance information about possible orders can help. Marketing matters most. I had read a book on Walmart 15 years back, wherein their software predicted demand (based on past information) for each item at each store, and automatically generated and sent orders and procured goods.
1.4 Once in a month, do a surprise check of ‘A’ items in stock, by counting actual quantity and comparing with quantity as per stock records. This step by the boss will keep all stock related staff on toes and reduce stock level, pilferage and cost of materials.
1.5 Stock loss report: Make it compulsory that each connected staff should report to the boss, any type of abnormal loss (pilferage, breakage, misuse, consumption, spoilage) within one hour. Many such losses are generally swept below the carpet.
1.6 Bring in simple/basic quantitative controls by way of monthly reporting. This is of extreme importance, but most companies shy from doing it.
1.7 Insure your goods sufficiently. I have seen that mostly this is not done.
2.1 Even a mother does not give milk until the infant cries. You have to request/coax/pester your debtors so that they pay early. Remember that your debtors have multiple bills to pay, so they will pay the most demanding creditors, first. Polite, weekly reminders are necessary. Do not hurt debtors unreasonably, by demanding money recklessly.
2.2 If you appear to be happy to receive money from debtors say after 3 months, then the debtor is a fool to pay you before 3 months. So do not create an impression that you are happy/cool/complacent. Be persistent. Do not be a banker to your debtors.
2.3 I have seen top companies print on their sales invoice the discount structure e.g. If paid with 1 month: 2% discount and other such offers. It may be sensible to consider offering discounts, at least to chronic debtors who pay late.
2.4 Try to take advances from customers. To this, the buyer may say payment on delivery. This too will help.
2.5 Master skill would be to have minimum debtors (with minimum discount being offered) and maximum creditors (without any interest payable). I know, it is easier said than done.
2.6 However, in case you get discounts on bulk purchases, do avail of it after considering the limitations as above of overstocking. A balanced approach is the ideal way.
2.7 If a debtor does not pay in 3 months, possibility of non-payment (fully or partly) can escalate dramatically, so do a vigorous follow-up after 2 months.
2.8 Needless to say, your terms to a customer should be competitive.
- Advances/deposits given:
See that there are no overdue amounts. Recover dues quickly. Avoid paying advances.
- General suggestions on working capital management:
4.1 First thing in the morning, you should review figures as below:
- a) Stock level: In rupees and in quantities of ‘A’ items.
- b) Debtors Outstanding: Outstanding for more than 1 month, 2 months and 3 months.
- c) Sales: Yesterday, last week and last month (with corresponding budgeted figures)
- d) Balance of cash credit (as per your books)
- e) Production: Yesterday, last week and last month (with corresponding budgeted figures)
- f) Recovery figure from debtors: Yesterday
I have observed in many instances that a business continues to struggle because of inadequate working capital. In most such cases, increase in owner’s capital is badly needed. However, the owner somehow carries on but his health suffers. On the other hand, the same owner has some properties/assets, which he clings to. I strongly suggest that in such cases, the owner should sell one of the property/asset and inject the money in his business. This will encourage the banker to lend more and the business can revive and thrive. My humble submission is if a property/asset can help the business (and his health), what sense does it make to retain it, unless it is earmarked for a certain purpose. A sold property can be re-bought but health/life cannot be.
To conclude, I shall narrate a true incident related to a professionally managed listed manufacturing company in Goa that happened a few decades back. I have witnessed it – The company CEO used to say that accounts is ‘donkey work’. Later, the company CA (finance manager) resigned and joined a Mumbai company. For a few months, no CA was there. Meanwhile, this CEO offered reckless discounts to foreign buyers without having the exact idea of the cost of production. The company ended the year in loss, with raw materials cost touching a staggering 87% of sales! The moral of the story is, kindly seek help of financial experts. A stitch in time saves nine. Also, rely on authentic data prepared by a good accounts team. One of the biggest contributors to a healthy business and to profit is sound working capital management. Even if you implement above suggestions fractionally, your business can reach a higher level.