Cash is King!

Small Business Capital Management

Article written by EricBank

Cash is the lifeblood of small businesses, because often they do not have alternative sources of funding. A company's current assets minus its current liabilities are its working capital. Cash and its equivalents -- short-term Treasury bills and commercial paper -- plus assets that can become cash within a year, such as accounts receivable, inventory and negotiable securities, are current assets. Debt due within a year, accounts payable, taxes payable, wages and salaries payable and other short-term liabilities are current liabilities. It's up to you to choose how aggressively or conservatively to manage your working capital.

Aggressive Management

The use of short-term credit coupled with minimal spending on current assets characterizes aggressive management of working capital. You are basically operating on a shoestring budget, cutting purchases of supplies and inventory to the nub while delaying bill payment until you start receiving threatening letters. You also aggressively try to collect your A/R. You must not delay interest payments or tax payments. Your creditors will sue and might force you into bankruptcy and liquidation. The Internal Revenue Service takes a very dim view of missed tax payments.

Conservative Management

At the opposite end of the spectrum, your working capital policy might be conservative: plenty of cash in the bank, inventory levels fully stocked and all bills paid on time. Your supply cabinets are full and employees need not justify a requisition for a new pencil. Typically, a conservative policy has a working capital ratio -- that's current liabilities divided into current assets -- of 2 or greater. In other words, for every dollar of current liabilities, you have $2 of current assets. Following this less-risky policy, you're not anticipating a cash crunch, but you might be getting a lower return, because cash in the bank doesn't pay much.

Risk

As you make your working capital policies more aggressive, default and bankruptcy risk increases. For example, if you have little cash on hand and are hit with a sudden emergency, you might have to default on an interest payment. Debtors might seize your property or wrestle the company away from you. In a less drastic example, if you skimp on inventory replacement, you're vulnerable to stockouts, lost sales and alienated customers. Your vendors might stop doing business with you if you string them along for several months before coughing up payment. If you want to float new debt, your deteriorating credit rating will raise your interest rates and make it harder to find new lenders. Conversely, if your working capital policy is too conservative, you incur opportunity costs by not working your money as hard as possible. This can lower your sales efficiency ratio -- working capital divided into sales revenue -- which can discourage investors in new debt and equity.

Return

An aggressive policy increases your return on assets, but hurts your bottom line by lowering your inventory levels, crippling sales and receipts. A conservative policy creates some lazy money that doesn't earn much of a return. The optimal working capital policy lies somewhere between the two extremes. Your goal is to minimize risks while maximizing revenue -- experience and experimentation will help you get it right.