Working capital, also known as net working capital, is a company's total assets minus total liabilities. Working capital indicates both the long- and short-term financial health of a company.
Negative and positive working capital fluctuations occur in companies at any stage of business and to this day remains a challenge for founders.
What causes a change in working capital?
Changes in working capital can be influenced by two primary factors:
- Operational business changes
- Market volatility
The good news is that business changes are typically made by leadership, so they remain in your control. Market changes, on the other hand, are uncontrollable factors. Despite them being out of your control, there are steps that can be taken to potentially mitigate and prepare for the changes.
1. Changes in business operations
When your production cycles or processes change, your products may take more or less time to produce. If the changes in your production cycle are going to be long-lasting or indefinite, it may be beneficial to look at how you can increase your profits or cut operating costs.
Research and development (R&D) comes with many benefits. While R&D may be a large upfront cost greatly affecting your working capital, it should be viewed as an investment rather than an expense. Oftentimes, the benefits of R&D can far outweigh any short-term drawbacks. R&D can result in increased profits in the long run, reduce future fluctuations in cash flow, and keep your business competitive.
Changes in payment policies
Have you implemented more flexible payment terms to your customers? For instance, maybe you extended customer payment terms in order to boost sales. While doing so may boost short-term profit, it could result in a greater risk of customers defaulting on payments.
Increasing credit from your suppliers could have a similar effect on your working capital as well. More flexible payment terms from suppliers will free up cash flow and allow you to increase your inventory at the same time. There's an even greater likelihood that your suppliers will offer a discount for purchasing more product in bulk. If this is the case, supply costs will rise in the short-term, but your inventory will increase.
While purchasing more inventory can immediately impact your bottom line, buying in bulk could negate any supply shortages, particularly when preparing for a high sales volume time of year like Black Friday/Cyber Monday (BFCM).
Changes in operating expenses
Changes in operating expenses could mean anything from increasing marketing spend to adding labour to increasing inventory. In the event that operating costs have varied, meet with your team to gain a greater understanding of where your operations budget is being spent.
2. Market changes
E-commerce founders know all too well the dreaded January dip in sales as customers tend to spend less after a major holiday. Most D2C companies experience a seasonal lull, though not always at the same time of year. Purchases of rubber boots and rain jackets, for instance, may skyrocket in April, but are likely to be in low demand by December. Of course, this particular example depends on factors like climate and geography.
While it may be worth putting more dollars in ad spend at peak season, it may be an interesting experiment to run promotions during slump seasons too. The most innovative founders are always looking for ways to boost sales volume and clear out any old inventory, no matter the season.
No matter your industry, new competitors always pop up. In the event of new competition and market saturation, companies that don't have a defined niche, strong brand differentiator, or convincing value proposition will struggle. Working with smart marketing and business partners can be the difference between market domination and going out of business.
Inflation seems to catch everyone off guard. Inflation can cause your profit to decrease while sending expenses through the roof. Lots of businesses tend to raise their prices in order to combat soaring costs of raw goods, shipping, and other peripheral expenses.
Forbes suggests that one way to combat fluctuations in inflation is to do any necessary borrowing early on. Once the value of the dollar drops, borrowing will become cheaper while inflation remains higher.
From plastic to truck drivers, there are shortages in almost everything right now. It goes without saying that supply shortages affect your ability to sell product. There aren't really any positive spins on supply chain shortages in today's day and age. Even once-popular practices like the Japanese-coined Just-In-Time (JIT) are now being criticized for causing supply delays. In a post-pandemic world, investing in inventory is the best plan of attack for founders everywhere.
Sudden changes in consumer tastes
Many different factors affect buyer taste. Ultimately this increases or decreases demand for your products and services. Online retailers in particular need to be ahead of the curve in order to combat a sudden dip in demand. Investing in R&D early on can be a solution for both marketing innovation and new product development.
How to chart the waters if you notice a change in working capital
First things first: don't panic.
Check in with your accounting manager or CFO to see what investments have been made recently that have caused this change in working capital. More often than not, the operational changes made by leadership are decided upon with the intent to scale.
Investing in a larger warehouse, deciding to purchase more raw goods or hiring a top marketing agency will inevitably come at a cost. You may have to ride the wave of negative net capital for a while. But making sound investments and taking on some liability could result in much longer periods of positive cash flow in future.
Founders can find peace of mind that cash injections for ads and inventory are readily available to overcome any changes in working capital. This allows you to continue to invest in marketing and inventory in order to pay for larger purchases like research & development to remain competitive.