Table of Contents
- Why is Cash Management Important?
- What is the Operating Cash Cycle?
- Enhancing Cash Management for Your Startup
- What is the Importance of Industry Benchmarking?
- What is the Effect of Cash Management on Working Capital?
- Managing Inventory and Receivables
- Managing Trade Payables and Negotiating Terms
- Key Takeaways
- Frequently Asked Questions
Startups need to manage their cash effectively to ensure their short-term financing is in order. This should be part of your wider strategy of working capital management. The concept of working capital management describes the extent to which your startup can meet its current liabilities. This article will explore the concept of cash management as part of a working capital management strategy for your startup.
Why is Cash Management Important?
Cash is the backbone of every business, and having a healthy cash flow is necessary to meet day-to-day expenses. This includes paying wages, overhead expenses, and obtaining supplies using cash as opposed to an external finance source such as credit.
Cash also serves as a precautionary function. For instance, if a major customer is facing financial difficulties, they may be unable to make their payments on time. This will eat into your cash flow. Having sufficient cash on hand ensures your business can fulfil its obligations and maintain stable operations.
Moreover, sound cash management enables you to act on opportunities when they arise. By holding cash reserves, your startup can take advantage of opportunities as they come up. For example, you may be able to acquire a competitor at a competitive price. In turn, this acquisition may positively impact your growth prospects.
What is the Operating Cash Cycle?
In the context of working capital management, financial managers have devised what is called the operating cash cycle (OCC). The OCC represents the time between cash outflows when purchasing inventory and cash inflows from credit customers when selling goods. A shorter OCC signifies better cash flow and reduces your financing requirements and financial risks.
To calculate the OCC, you can use the following formula:
Here, ‘Days Inventory Outstanding’ refers to the average time it takes to sell your inventory. Whereas ‘Days Sales Outstanding’ represents the average collection period from credit customers. Lastly, ‘Days Payables Outstanding’ indicates the average time taken to pay suppliers.
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Enhancing Cash Management for Your Startup
Reducing the OCC can significantly enhance your startup’s cash flow and working capital. Here are some strategies your startup could use to achieve this:
- Efficient Inventories and Credit Control: Improving your inventory control and credit control procedures reduces the average time taken to sell inventory. In turn, this reduces the amount of time taken to collect payments from credit customers. Ultimately, this shortens your OCC.
- Negotiating Payment Terms: Your startup may be able to negotiate better payment terms with suppliers. This has the effect of increasing the average time you have to pay trade payables. However, this must be done carefully to avoid breaching supplier agreements.
- Combining Multiple Strategies: Your startup can achieve a 30-day reduction in OCC by making adjustments to your inventories, trade receivables, and trade payables periods.
What is the Importance of Industry Benchmarking?
Benchmarking your startup’s OCC against industry averages is essential to gauge your cash flow performance. You may find it helpful to instruct a business analyst to gauge how your OCC compares to similar businesses. This information can help you assess how well your startup is managing its working capital compared to others in the industry.
What is the Effect of Cash Management on Working Capital?
Effective cash management has a direct impact on your startup’s working capital. Working capital is essentially the difference between your startup’s current assets and current liabilities. Current assets include any cash, inventory or trade receivables your startup has. In contrast, current liabilities include any trade payables or other financial obligations your startup has with creditors. Maintaining an appropriate level of working capital is crucial for day-to-day operations and growth opportunities.
By reducing the OCC, your startup can optimise the cash flow and free up otherwise tied-up short-term capital. This freed-up capital can greatly benefit your startup. For example, you may invest this money in long-term projects. Additionally, you could use this money to purchase additional inventory. You could also use this money to jump on profitable opportunities as they arise.
Managing Inventory and Receivables
One of the primary contributors to the OCC is the time taken to convert inventory into sales and collect payments from credit customers. As a startup, it’s essential to manage these aspects efficiently.
Inventory Management
Maintaining an optimal level of inventory is crucial to avoid excess carrying costs while ensuring you can meet customer demands. The following suggestions can help you optimise your inventory management:
- implementing inventory control systems;
- adopting selective just-in-time inventory practices; and
- monitoring sales trends.
Credit Control
Offering credit to customers can attract more sales. However, it also exposes your startup to the risk of late payments or bad debts. To mitigate the likelihood of this occurring, you should consider the following:
- establishing clear credit policies;
- conducting credit checks on potential customers; and
- implementing appropriate accounts receivable procedures.
These proposed measures can help reduce the extent to which your trade receivables remain uncollected.
Managing Trade Payables and Negotiating Terms
On the other side of the operating cash cycle, managing trade payables is equally crucial. While you aim to extend payment terms to improve cash flow, it is important to maintain good relationships with suppliers. You want to avoid any disputes which may result in potential disruptions to your startup’s supply chain.
Payment Terms Negotiation
Negotiating favourable payment terms with suppliers can help your startup extend the ‘Days Trade Payables Outstanding’ and preserve cash. However, it’s essential to strike a balance between stretching payment periods and maintaining good relationships with suppliers.
Vendor Relationships:
Maintaining strong vendor relationships can lead to benefits such as early payment discounts and improved supply chain efficiency. Maintaining a positive and transparent communication channel with suppliers is key to ensuring mutually beneficial partnerships.
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Key Takeaways
Cash management plays a necessary role in managing your startup’s working capital and overall financial health. By optimising your Operating Cash Cycle (OCC), you can streamline your cash flow, reduce financing requirements, and improve your business’s underlying credit.
If you need help understanding how effective cash management could improve your startup’s working capital, contact our experienced startup lawyers as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Effective cash management ensures that your startup has sufficient reserves to meet economic downturns. Also, sound cash management ensures your startup has sufficient cash to jump on any potential opportunities.
Striking a balance between cash reserves and investments requires your startup to carefully evaluate several factors. You need to consider potential returns on investments, assess risks, and maintain adequate cash reserves.
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