One of the most common reasons a business runs out of cash is because it runs out of operating cash or working capital (whatever that is?)
Working capital is current assets less current liabilities.
Current assets – they’re things like stock and your debtors (what your customers owe you)
Current liabilities – well they’re things like creditors, the amounts you owe other people, the tax man and short term debts.
The working capital formula looks something like this…
Working Capital = Current Assets (stocks and debtors) minus Current Liabilities (creditors, money owed to suppliers, short term debt)
It’s not particularly helpful is it?
So here’s a really simple way to demonstrate it…
Let’s meet Betty!
Betty sells bobble hats!
Business is booming and sales are growing at a very steady rate.
Betty sells her hats from stock and she gives her customers 60 days to pay her.
But, she buys her hats from her suppliers who only give her 30 days to pay.
Are you beginning to see the problem?
Betty is buying more and more stock and her suppliers are working really hard to keep up.
Now Betty is stuck. The problem is not solved just by selling to more customers. Because that just makes that gap bigger and bigger and Betty has run out of cash.
She has no more cash to buy stock to fulfil all those unfulfilled customer orders.
Betty has run out of working capital.
Or, to put it another way, Betty is overtrading.
Crazy as it may seem, her business is booming yet she has ran out of cash.
She is trading over the cash resources she has available in her business.
So what can Betty do?
- She can go to her customers and see if she can get them to pay her quicker.
- She could do the same thing with her suppliers. She can see if they will give her 60 days too which would close that gap.
- Alternatively she can say to her suppliers can she have consignment stock? That way she pays for the stock when she sells it not when she buys it from them.
- She could look at financing the business differently. It may have reached the size where she needs to introduce some funding.
So get your thinking bobble hat on and work out how you can manage your working capital better.