Only if.. I just had ... a little... more $$$

Ever heard this line before? or wondered, what drives this wishful thinking? 

Failed startups are often heard saying “we ran out of money and hence time”. This is because they are typically so focused on building their product, they don't keep a check on their cash flow requirements, especially working capital. As a result, many startups run out of money, stalling out before they reasonably had a fighting chance.

Why working capital management matters for startups?

According to a report by CB Insights, among the 20 primary reasons why start-ups fail, the No. 2 cause is that they “ran out of cash”. 

Several reasons why this might happen. One could be because they failed to raise adequate capital, especially now when funding winter has descended on startups globally. For running businesses, it could also be because they did not manage their working capital well. Founders must manage their assets and liabilities efficiently to keep the business running. 

There are times when factors beyond their businesses could hurt as well. For example, during the nationwide lockdowns, small businesses suffered the most, with their revenues almost down to zero and no external funding, startups had to cut jobs and salaries to sail through. However, many startups failed because they simply ran out of cash.

Working capital is an effective way to measure any company's short-term financial health, liquidity, and operational efficiency. In fact, even if a startup is not making profits as a business today, if it manages working capital well, it will get there sooner than later.  

What can go wrong?

Many business owners focus on the numbers on their balance sheet without paying attention to their cash flow needs. To keep a company running, founders must take charge of their working capital. Otherwise, it could hurt their ability to pay bills. 

Working capital has 4 components: inventories, accounts receivable, accounts payable, and cash, a well-run firm manages all these 4 components, albeit steadily.

For small businesses, delays in payment from clients can be distressing. Being a small company, startups can't confront their more prominent clients for delays beyond the promised payment cycle. Founders have no option but to wait for clients to clear dues. In the meantime, they need to pay employees and meet tax obligations. There are penalties for delays in paying tax deducted at source or TDS and Goods and Services Tax or GST. The government is not bothered whether clients are not paying on time or not. In all fairness, though, during the pandemic, the government eased rules for small businesses on paying taxes and filing returns. 

Another factor that could lead to cash crunch in startups is too much dependency on a few clients. To generate more revenue, founders may ignore other clients and focus on that one big institutional client. Any delays in payments from that client could cause significant distress to operations. The business will run out of money to pay employees, taxes and vendors. For example, a healthcare services company provided supply chain solutions to the hospital and pharmaceutical sectors. The founders decided to focus on one institutional client and worked on the broader product portfolio. They spent money upfront and then waited for the client to pay. The client delayed payments to such an extent that it had to be wound up. 

Such practices can devastate businesses and those who depend on them for work. Startups should remember to avoid depending on one or two big clients in the case of a B2B business. 

Moreover, factors such as interest rates, market demand for business output, economic status, currency rate, and seasons (or market trends) greatly impact working capital management. Inter-connections between these aspects make managing working capital an intricate affair that requires a great deal of attention. Business owners should have a sufficient cushion to guard against such a situation. 

What can companies do?

If you have shareholders besides you to look after, you must regularly inform them about your business strategy. An experienced investor will warn you against anything that could jeopardise cash flows. 

Like when you invest in the stock market, you choose mutual funds to diversify your risk. You must work with multiple customers for income. Your business needs a stable source of income. Having clients of varying sizes could help avoid dependence on one or two large clients. 

While your client payments could get delayed, your commitments to your employees, workers and the government need your timely action. Keep your expenses in check to ensure that you have that necessary cushion against potential payment delays. For small businesses, every rupee earned in revenue counts. 

Keep a tab on inventory ageing to avoid old inventory piling up. This is critical because slow moving inventory can add up into a large issue if not addressed in a timely manner. 

How and when to raise money has always been a critical issue for start-up executives, who have to weigh the benefits of putting cash in the bank versus maintaining greater control and a bigger stake in their company.

How to master working capital management?

There are several theories online explaining the concept of working capital management. However, for one to master it as a business owner, he/she requires only experience. There will be several valuable lessons in situations that strain payment cycles of business. On most occasions, owners bring in the necessary cash to keep operations going in situations of delayed client payments or low profits. However, as businesses scale up, they would have to generate sufficient cash for operations and leave money for shareholders. Generating steady cash flows will allow companies to better attract additional venture capital down the road.  The other situation could be if they do not hustle enough and end up with inventory. Businesses will then have to spend money on maintaining that inventory if they are also manufacturers.

If you are new to the business world, you may want to start by knowing the importance of working capital management well. You can get new investments only if people get confidence that you can manage your current assets and liabilities efficiently. It is only then that they will trust you with their money.