Understanding How to Manage Capital

Cash is the lifeblood of small businesses, because often they do not have alternate sources of small business 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 restricted budget, cutting purchases of supplies and inventory to the nub while delaying bill payment for as long as possible. 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. The proper use of convenient commercial small business loans, such as those available from IOU Financial, is a vital component in managing your working capital in an aggressive manner.

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. In effect, to buy some peace of mind, you are sacrificing profits and returns, because you are not leveraging your small business financing. The proper use of credit can help correct a capital management style that is too conservative.

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 encounter a sudden emergency, you might have to default on an interest payment. Debtors might seize your property or wrestle the company away from you. This is precisely the time to take out a convenient commercial small business loan to get over the rough spots. In a less drastic example, if you skimp on inventory replacement, you’re vulnerable to stock outs, 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. A commercial loan is the best recourse in these circumstances. 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. Use small business loan proceeds to leverage you operations and increase you return.

Return

An overly aggressive policy increases your return on assets, but hurts your bottom line by lowering your inventory levels and crippling sales. However, the proper use of credit can avoid these problems while maintaining healthy returns. 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. In just about every situation, consider the use of a commercial lending facility to optimize your return while managing your risks.

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