How Do I Manage Working Capital for My Startup?

Sound management of working capital is crucial for startups. As a startup owner, you are likely familiar with the term “working capital”. This is an accounting and legal comparison between your current assets and liabilities. This article will explain how your startup can best manage its working capital. 

What is Working Capital?

You can calculate working capital by looking at your startup’s current balance sheet. The formula is:

The most important current assets for working capital are:

• inventories;
• trade receivables (i.e. issued but unpaid invoices); and 
• cash and cash receivables (i.e. all the cash your startup has in the bank account). 

The two most important current liabilities are your startup’s:

• bank overdraft; and 
• its trade payables (i.e. supplier invoices you have not yet paid). 

Industry Considerations 

The nature of your startup’s working capital depends on the sector you operate in. For instance, manufacturing startups will have significant inventories of raw materials, works in progress, and finished goods. If you have a manufacturing startup, it will sell its goods on credit, which translates into significant trade receivables. 

On the other hand, if your startup is a retailer, your inventories will only consist of unsold stock. You will then sell this stock for cash (rather than on credit). 

If your startup is a service provider, such as a SaaS or fintech, you will not have any inventories, though you may sell your services on credit. 

In essence, working capital management for startups will depend on the sector the startup operates in and its own circumstances.

What is the Purpose of Working Capital Management?

Effective working capital management holds great importance for startups. You can think of working capital as a net investment in your startup’s short-term assets, such as your inventories, cash, and trade receivables. 

These current assets move in and out of your business based on its operations. Consider the following process of a manufacturing startup:

1. You acquire raw materials from a supplier, which you need to manufacture your goods. As a result, you incur a liability in the form of a trade payable. 
2. The acquisition of raw materials is a corresponding asset on your balance sheet. Your business uses these raw materials to begin the manufacturing process. 
3. You transform the raw materials to works in progress and then to finished goods. 
4. You sell these finished goods to customers, transforming inventory assets into trade receivables. 
5. At which point, you collect on your invoices; your trade receivables become cash. You use this cash to pay off your supplier, which supplies you with further raw materials. 
6. The process repeats itself. 

This process again depends on your startup’s industry. However, maximising the efficiency of this process will ensure that your startup generates the largest return on the investment in your short-term assets. 

Factors that Influence Working Capital Management 

These factors below influence the working capital management policy of startups:

• interest rate changes; 
• change in demand for your product; 
• price changes for any supplies or overhead expenses; 
• seasonal changes; and 
• tax and import/export policy changes. 

To illustrate, higher interest rate environments means you will pay more interest on a daily basis for any outstanding overdraft you have with your bank. As a result, you may prefer to delay settling your trade payables until you have sufficient cash on hand rather than drawing on your overdraft. 

How Do I Manage Working Capital for My Startup?

Working capital management requires your startup’s managers to decide how much of any one current asset it should have on hand at any given time. This is because each asset entails a corresponding cost, with some assets costing more than others to keep around. 

These costs include the actual expense of acquiring your current assets, such as paying down an invoice using cash. But it also includes the opportunity cost of holding one current asset over another. For instance, pre-purchasing raw materials in cash may give you an upfront discount on bulk purchasing. However, you lose any interest that might otherwise have accrued on the cash in your current account. 

Likewise, while you may prefer converting trade payables into cash as soon as possible, too aggressive of a collections policy may strain customer relationships. 

Broadly speaking, you can approach working capital management by closely examining the following four working capital components:

1. Managing Inventories

Before the pandemic, businesses with inventories generally kept their inventories as minimal as possible. This is because holding inventories means your startup incurs the following expenses:

• storage and handling costs;
• inventory financing costs; 
• theft and damage;
• obsolescence; and
• opportunity costs. 

However, when the global supply chain was disrupted as a result of the COVID-19 pandemic, businesses quickly learned that “just-in-time” inventory management increased the risk of:

• loss of sales and customer goodwill if your business cannot supply the goods advertised; 
• paying a premium to replenish depleted inventories quickly; 
• lost production due to raw materials shortages; and 
• inefficient production. 

By undertaking a comprehensive demand forecast and implementing adequate recording and recording systems, you can ensure your inventory management balances the costs and risks. 

2. Trade Receivables Management

If you sell goods or services on credit, you will have trade receivables. You can manage your trade receivables by ensuring that you undertake appropriate credit checks on your customers to ensure that they can pay any invoice. You will want to implement sound collections systems that balance prompt collections without sacrificing your customer goodwill. 

Additionally, you can look into solutions like offering discounts to customers for immediate cash payments. Alternatively, you can smooth over cash flow problems by entering into factoring or invoice discounting arrangements with specialist finance providers called factors. 

3. Cash Management

To effectively manage your startup’s working capital you will need sound cash management procedures in place. On-hand cash ensures you can meet liabilities immediately if necessary without having to pay for credit. If you opt to obtain credit from a lending institution this will represent an external financing solution. In turn, you will likely receive funds via an overdraft or invoice discounting arrangement. However, too much cash on hand means you are not fully investing the cash into more growth opportunities. 

If your startup has robust cash flow projection systems, you can determine more precisely how much cash you will need at any given point in time. 

4. Trade Payables Management

If your startup purchases goods or services on credit, it will incur trade payable liabilities. There are benefits to trade payables, including the fact that it operates as a spontaneous source of finance for your business. That is, you can acquire necessary goods and services immediately without recourse to other forms of finance that come at cost. 

However, the costs of trade payables include increased administration costs and fewer opportunities to acquire your goods and services at a discount in exchange for cash payment. 

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Key Takeaways 

You as a startup owner need to actively manage working capital for efficient operations. Working capital comprises short-term assets such as inventories, trade receivables, and cash. Management decisions are influenced by industry dynamics, interest rates, and demand fluctuations. It’s essential that you strike a balance in inventory levels, optimise collections, maintain cash reserves, and manage trade payables effectively. By doing so, your startup can maximise the utilisation of working capital to meet short-term financial obligations and drive overall business success.

If you need help understanding how to effectively manage 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. 

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