Business Analyst - June 23

Thursday, June 23, 2022
ENTERPRENEUR
Working Capital Management –
Achieving Higher Profitability
WHAt comes to
your mind
when you
think about
the financial
performance of a business? Is it the
profit/loss given at the last line of
an income statement? Although
that’s one of the strong measures to
analyze the financial performance
of the business, it does not offer a
comprehensive perspective to base
all of your decisions on that single
metric. this is due to an inherent
limitation of the profit/loss that
comes with subjective
assumptions, accounting
estimates, and adequacy of the
transaction-related controls.
(wikiaccounting, 2021)
Hence, there is a need to
consider cash flow operations
which are more objective and lead
to enhanced accuracy of the
decision making and financial
analysis. But, the question arises of
how to perform cash flow analysis
with perspective to working capital
management and how
startups/businesses can control
their cash flows to achieve higher
profitability.
How to perform cash flow
analysis with perspective to
working capital management
Generally, cash flow is divided
into three main categories:
operating, financing, and investing
activities.
operating activities are about how
businesses manage their day-to-day
operations. these operations consume
working capital/financial resources. As
we understand, interest/dividend is
payable on raising debt/equity (financial
resources). So, there is a cost associated
with raising finance and using it as
working capital.
Hence, businesses tend to optimize
their operations and streamline their
processes so that the length of the
working capital cycle decreases.
Working capital cycle refers to a
complete process of trade. It involves the
length of time required to purchase, hold,
and collect receivables from the
customers. So, if the business has a
shorter working capital cycle, it can
complete the trade process in a shorter
time to earn higher profit within the
business’ working capital cycle and vice
versa.
So, a shorter working capital cycle is
desirable from the perspective of
financial analysis, achieved with the
shorter production time, shorter
inventory days, shorter receivable days,
and higher payable days. It’s important
to note that higher payable days is more
desirable as it brings financing within
the business without any cost (in most
cases).
It means there is a direct
connection between the performance
of operational business activities and
the achievement of business
profitability. If activities like sales,
production, and collection are performed
with higher efficiency, there are higher
chances of profitability, and vice versa,
generally speaking. So, if the working
capital cycle is shorter, it leads to a lower
cost of financing and higher business
profitability. the next question arises
how business can control cash
operations/working capital to achieve
higher profitability.
How businesses can control cash
operations/working capital cycle to
achieve higher business profitability
Control of cash operations require a
disciplinary approach to plan, measure,
monitor, and take corrective actions for
the cash-related operations. the
following actions can be helpful in the
effective management of the cash-related
functions/working capital.
Measure your current
cash runway
Cash runway refers to the time your
business is expected to sustain without a
need to raise finance from external
financing sources. It considers opening
cash position, expected cash inflow and
outflow of cash during a period under
consideration (SrJ Chartered
Accountants, n.d.).
For instance, let’s say your opening
cash amounts to $10,000, the expected
inflow is $5,000 a month, and the
expected outflow amounts to $6,000 a
month. the given cash outline suggests
more outflow of cash than inflow. Hence,
opening cash needs to be able to support
the shortage. However, opening cash is
limited and expected to support the
business to a specific period called cash
runway.
Cash runway in the given case can be
calculated as follows.
Cash shortage during a month =cash
outflow – cash inflow
Cash shortage during a month =
$6,000– $5,000
Cash shortage during a month =
$1,000
Cash runway = opening cash/cash
shortage during a month
Cash run ways = $10,000/$1,000
Cash run ways = 10 months
the current cash runway is 10
months. this means, in the
circumstances specified,
the business can sustain
itself for exactly ten
months without raising
finance from external
sources (for working
capital purposes). So, the
strategic decisionmaking
persons of the
company must consider
the length of the cash
runway to adequately
plan the cash needs of
the business.
Setting cash runway
as a benchmark can be a
helpful measure to
control cash-related
performance.
A comprehensive
evaluation of cash flow
in terms of revenue and
expenses
If your business has
more expenses than
revenue, it can be taken
as an alarming sign; the
situation is termed as
”burning cash”. So, there
is a need to reduce the cash-burning rate
that can be achieved with implementable
smart moves to enhance revenue.
For instance, finding a new market to
“Operating activities
are about how
businesses manage
their day-to-day
operations. These
operations consume
working
capital/financial
resources. As we
understand,
interest/dividend is
payable on raising
debt/equity (financial
resources). So, there is
a cost associated with
raising finance and
using it as working
capital.