Drought brings with it many challenges, but one of the most notable is the financial difficulties that are endured during an on-going drought.
Being adequately prepared is an integral step in minimising your exposure and any associated financial issues.
Along with having a risk management framework in place, it is important that you implement a structured approach to managing your business finances and operations to ensure there is sufficient working capital during both normal, and dry, conditions.
ABDI Advisor, Lee O’Dwyer, is a chartered accountant with over 15 years of senior financial, corporate and business expertise. We’ve asked him to provide his insight and expertise on this topic.
What is working capital?
Working capital is essentially the capital your business has available on a day-to-day basis once you’ve considered all your short term debts (current assets – current liabilities = working capital).
A key component of working capital is the cash reserves of a business – a ‘liquid’ asset available to meet needs as they arise. Cash is King, and like oil to an engine, it can be thought of as the lubricant needed to ensure a business runs well.
Why is working capital so important?
A key concept to understand is that profit does not always equal positive cash flow.
Although a business may have long-term profitability and appears to have a robust future, poor management of working capital might result in that business’s failure due to short-term solvency issues. To trade while insolvent has serious legal, financial and other implications.
By understanding and maximising the use of your working capital, you’re essentially working to improve the overall success of your business.
In the good times
When the seasons are good and business is booming (noting growth issues just below), effectively managing your working capital may seem easy. However it is still important not to be complacent, and to ensure you have the systems in place to manage any changes to your business and the business environment when they arise.
During the prosperous growth periods of a business, additional working capital may be required due to increasing inventory and trade receivables balances (money you are owed after selling your product), as well as additional funding for investment in new plant and equipment purchases.
In the dry, difficult times
When times are challenging and you might not be investing in new plant and equipment, or moving much of your stock, there will still be expenses to pay. The ability to pay debts as and when they fall due is crucial part of running any business, regardless of your circumstances.
Failure to forecast or effectively manage working capital can result in cash shortages and cash flow problems, which may result in:
- Struggling to make scheduled loan repayments or purchase necessary inventory;
- Your individual and business reputation being damaged due to not making supplier payments;
- Your staff start mentally checking out or looking for other jobs, to name a few.
How to manage your Working Capital effectively – for all situations
In order to ensure your business has sufficient working capital to manage all potential business scenarios, some key activities should be undertaken, including (but not limited to):
1. Create a Business Plan. Taking to time to think about the future, and consider all potential scenarios (changes in climate, changes in consumer demand and the marketplace etc), will enable you to be more prepared.
2. Understand your business’ working capital cycle. The working capital cycle is shown in the diagram below and shows all the various areas that should be considered when managing working capital. The preparation and comprehension of a Statement of Cash Flows for your business is a key part of this – and all business should use this tool to help understand cash flows.
3. Make Budgeting and Forecasting a routine and regular habit in your business. Budgeting and forecasting are tools used to keep the business on track and to understand where it is going. Looking ahead allows you to predict with confidence and manage any foreseeable issues on the horizon, allowing you to prepare before such issues become a problem.
4. Continually Monitor & Evaluate. Continuous understanding of your situation allows for changes and adjustments to adapt to the changing business environment. By doing this on a regular basis, you are ensuring that the information on hand is always accurate and up-to-date, and that any resulting decisions being made are based on accurate, relevant data.
Staying in control
Undertaking the above, coupled with implementing appropriate systems for wider financial and business management:
- Allows you to maximise opportunities. Understanding and having confidence in the financial position, including short-term liquidity, of your business empowers you to make swift, decisive and fact-based decisions, and gives you the ability to take advantage of opportunities, as and when they arise.
- Protects you against risks and builds resilience. Understanding the overall financial and working capital position of your business is the first step in developing business resilience. Developing a greater understanding of your business through the creation of appropriate systems will enable the identification of any weaknesses and potential ‘pinch points’, and develop strategies to manage these areas, so there are no surprises if and when such difficult times arise.
How can ABDI help you?
Our advisory team includes financial experts who are well-versed in setting up cash flow reports, and providing education and advice on how to manage your business finances. If you would like to speak to an advisor about your business needs, and learn how to manage your finances more effectively, simply book in for a free consultation today.