7 working capital mistakes to avoid at all costs
Working capital is the backbone of a business. By definition, it is the funds available to a company for managing daily operating expenditures and paying off short-term liabilities. Working capital thus enables a business to work and continue its day-to-day operations. Business owners must be cognizant of their working capital mistakes and must also examine and address them from time to time.
Poorly used working capital not only results in losses but can also derail the business in the long term. While no business will fully mismanage its working capital, a slight oversight in day-to-day operations can result in working capital management mistakes.
Here are 7 working capital mistakes that can cost you your business, if not identified and corrected in time:
1. Unplanned expansion
Not taking into keen consideration the additional cash requirements to fund your growth and expansion plans can put a strain on your working capital. If your growth plans do not succeed or do not provide the estimated business, you can end up borrowing funds at a higher interest cost, just to manage daily operations and keep the firm running.
2. Poor production planning
If your business forecasting and production planning are constantly off the mark, especially if you are producing more than you can sell, you end up tying your working capital in raw material and in managing and storing the excess inventory. While this is one of the most common and costly working capital mistakes, it can be kept in check by regular analysis of your sales forecast and timely corrections to it so that your procurement and production plans can be corrected, as per business needs.
3. Extending high credit period
More often than not, businesses extend the credit period beyond their usual norm to get new businesses, maintain business relations or keep the account running. For example, their normal credit period might be 30 days, but to get business they might extend it to 45 days or 60 days. While this is not completely avoidable, making it a regular practice or extending credit to all customers can adversely affect your cash flow and thus, your working capital.
4. Neglecting the collection of accounts receivables on time
Your account receivables are your main source of working capital funds. Not having a proper collection process or failing to collect dues from customers on time can put a strain on your working capital. Unfortunately for quite a few businesses, collecting accounts receivables is like Achilles’ heel. While it appears as an asset in the balance sheet, it can easily turn into a liability for the company in the form of loans acquired for daily operations at a higher interest cost.
5. Relying on vendors for working capital
It is common for businesses to ask vendors for extended credit periods to tide through low cash situations. For example, your vendor gives you a credit period of 30 days, but you are not able to pay on the due date as your funds are running low. You ask for another 10-15 days to clear the dues. While using vendors as a source of credit is a reasonable working capital strategy, it comes at a cost. Frequent delays in vendor payments could lead to vendors losing trust in your business. This could result in delayed supplies or vendors refusing to extend your credit.
6. Not taking an advance on large orders
Catering to large one-time orders requires additional funds. Other than the investment in extra raw material, sometimes additional manpower and machinery are also required to complete huge orders. If you do not take an advance to cater to the additional expenditure or avail of a bank loan, it has to be funded through your working capital. This can lead to a shortage of funds, as large orders may get delayed.
7. Neglecting to account for short term liabilities and contingencies
Apart from the payables to suppliers and vendors, companies can have other short-term liabilities in the form of loan EMIs, lease renewals and income tax. All these expenses reduce the funds available as working capital. If these short-term liabilities are not taken into account when calculating the working capital requirements of the firm, it can create a cash shortage when the payment is finally due. Similarly, there remains a need to allocate funds for unforeseen events/contingencies. For example, a rise in the transport cost owing to fuel price increase, labours demanding pay rise/overtime wages, etc. are not forecasted, but can certainly happen. To ensure that these events do not hamper the day-to-day working, it is necessary to set aside funds for these.
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