During any challenging environment, liquidity is king — cash allows a business to meet payroll, fund vendor purchases, prudently extend credit to customers and meet fixed obligations, such as rent, principal and interest payments on debt and other payments required to keep the doors open.
In this installment of the “How to Prepare for a Recession” blog series, learn about working capital and how to calculate how much cash a company should keep on hand.
WHAT IS WORKING CAPITAL?
Working capital is defined as the difference between current assets and current liabilities on the balance sheet.
Generally, current assets include:
- Cash
- Accounts receivable
- Inventory
- Prepaid expenses
On the other hand, current liabilities include:
- Accounts payable
- Accruals such as payroll, taxes and payment of leases
- The current portion due of long-term debt and lines of credit that mature within the year
MAXIMIZE WORKING CAPITAL
The goal of any business is to maintain an adequate working capital position to keep dry powder for an unforeseen situation (particularly important during a downturn and could include funding opportunistic acquisitions) and to survive and position for the upturn in business fortunes.
To maximize working capital, faster “turns” of receivables and inventory requires less cash needs, as do longer turns of payables. There are business considerations to intentionally speeding up or slowing down these line items, which are addressed later in this post.
HOW TO INCREASE LIQUIDITY
Consider the revised sales forecast and scenario creations covered in the last two installments of this series. There may be lower inventory requirements and, if a line of business is eliminated, obsolete inventory. What are the true inventory needs in a changed forecast, and can the business liquefy now-obsolete materials or finished goods to generate additional cash?
For receivables, a company may want to consider two actions:
- Talk to customers about how they view a potential recession. If you perceive significant threats to their viability, consider whether or not to extend additional credit in the forms of payment terms or to sell on a C.O.D. basis.
- Do not let receivables go out any longer than 60 days, and be proactive in collecting amounts due.
This is also a good time to take a step back and consider the overall customer list. It is essential to cull troublesome customers, low-margin customers and those that do not fit a revised plan, if it has been developed.
With accounts payable, there is a fine line to walk between stretching out the time taken to make those payments and staying in good graces with any vendors, particularly if there is a time-sensitive critical nature to the materials they provide. As companies are being diligent with any over-60-day receivables, vendors will do the same.
FORECASTING IS KEY
Forecasting can also be a helpful tool when looking to increase liquidity. Forecasts prepared by GHJ’s team include a three-statement analysis:
- Balance Sheet
- Income Statement
- Statement of Sources and Uses of Cash
These statements tie together in GHJ’s forecast models to provide robust decision-making information for owners; knowing how much working capital to have on hand is an important part of this equation.
In the next installment of this series, learn more about maintaining a relationship with capital advisors. To learn more about working capital or preparing for a recession, contact GHJ’s Growth Planning and Strategic Advisory team.
