Why is Working Capital Important for Cash Flow Management?

What is Working Capital?

Working capital refers to:

• Inventory (Stock that we have in our warehouse)
• Creditors (Companies we owe money to) and
• Debtors (Companies who owe us money)
• Cash (Money in the bank)
  
  Inventory, creditors and debtors have a direct impact on the amount of cash in our business.
  
  WHY IS THAT?
  
  The timing of all of the above affects the cash requirements of the business:
  
• Taking too long to sell my stock means that I will incur lots of costs to store the stock at my warehouse.
• If my debtors don’t pay me on time, I won’t have enough cash to pay my creditors and will have to borrow from my overdraft
• If I order too much stock that can’t be sold, I won’t get back the money I spent on purchasing the stock.
  
  A working capital policy sets out rules for the business so that the working capital can be managed in line with what the business needs:
  
  A working capital policy covers things such as:
  
• Requirements for companies to meet in order to buy on credit from us
• Early payment discounts for Debtors in order for them to pay early
• Tracking our inventory levels so that we don’t have insufficient stock or too much stock

It sounds quite confusing hey?

Let’s demystify it with 3 short examples which will illustrate the relationship between reducing inventory holding times, getting the customer to pay earlier and the cost of a late paying customer:

• 1: Customer pays on time with no early payment discount
• 2: Customer pays early with a 5% discount given
• 3: Customer pays 30 days late

Example 1: Customer pays on time with no early payment discount

Consider the following example that highlights the impact of a working capital policy that does not provide the customer with an incentive to pay early:

We bought the stock on Day 1 from the supplier on Credit.

Between day 1 -15 we keep it in the warehouse and we pay R1 per day for storage (R15).

We sold it on credit on day 15 for R150.

Our customer payment days is 30 days. On Day 30 we still haven’t received payment from our customer as payment from them is only due on day 45.

On Day 30, we have to pay our creditors and this results in us borrowing from our overdraft. The Overdraft Charges are R1.5 per day (1.5×15=R22.5).

On Day 45 (30 days after the customer bought from us), the customer pays us the R150.

As a result of our customer and supplier payment days not being aligned, the following costs were incurred:

The holding cost and interest are costs that has been incurred because:

• Inventory was not sold quickly
• And the customer did not pay on time

Example 2: Customer pays early with a 5% discount given

In this example the customer pays on time and we have reduced the number of days we are holding the inventory before we sell it.

We bought the stock on Day 1 from the supplier on Credit.

Between day 1 -7 we keep it in the warehouse and we pay R1 per day for storage (R7).

We sold it on credit on day 7 for R150.

We have incentivised our customers to pay us early by providing them with a 5% discount if they pay within 14 days so they pay us on Day 21.

On Day 30, we settle our account with our creditors of R100.

Let’s look at the impact on our net profit of having an early settlement policy and of reducing the holding times of inventory:

Reducing our Inventory holding time has reduced the holding cost from R15 (Example 1) to R7.

We have an expense related to the Discount that we have given to our customers, but we have not incurred any interest on overdraft.

Example 3: Customer pays 30 days late

In this Example, our customer is paying us 30 days after their payment is due.

We bought the stock on Day 1 from the supplier on Credit.

Between day 1 -5 we keep it in the warehouse and we pay R1 per day for storage (R5).

We sold it on credit on day 5 for R150.

Our customer is having some financial trouble this month and can only manage to pay us 30 days after the payment is due. Payment was due on day 35 and they only pay on day 65.

In order to settle our account with our creditor on Day 30 we borrowed from our Overdraft and incurred R1.50 of Overdraft charges per day. (R52.50)

We also had to hire a Debtors clerk to keep following up with the Debtor and her salary amounted to R2 per day (R60).

In terms of the National Credit Act, we are allowed to charge them 2% per month on outstanding debt if they don’t pay within the specific time (2%*150=R3).

As we can see from the above example, the impact of the debtor not paying on time is:

• Quite costly in the long run and
• Has one of the biggest impact on the cash flow of the business.

So there you go, a brief introduction to how working capital affects the Cash Flow of the business. In this post, we highlighted:

• The impact of a customer paying early after they have been provided with an incentive
• The impact of reducing inventory holding times
• The financial impact of customers paying late

There is so much more to cover, but I hope that this answered at least some of your questions.

Check out these other posts about Cashflow:

5 Common Reasons for Cashflow Struggles