Every business needs working capital to operate. Most employees, landlords and suppliers are unwilling to provide their services for free until you secure and get paid for a big sale or project. This means your business will have a significant amount of cash tied up at any specific time.
Knowing where your cash goes each month can help you better manage and grow your business.
Labor, phones, materials and other typical business expenses are relatively easy for owners to track, because they can be found on a standard profit and loss statement. Other cash costs like inventory carrying costs, interest expense, changes in accounts payables and capital spending can be more difficult to get a handle on.
But not with your balance sheet in hand. This common accounting statement can provide a wealth of information on where your cash is going each month. Usual suspects include:
Customer and Supplier Financing
A large amount of cash may be tied up funding your customers or suppliers. For example, if you allow your customers 60 days to pay their bills, you are essentially giving them a 60-day loan.
Likewise, if you are buying more inventory than you can produce or sell right away, or paying cash on delivery instead of waiting 30 days to pay suppliers, you are extending credit to your suppliers.
On your balance sheet, customer credit is listed as “accounts receivables,” while vendor credit is listed as “accounts payable.” If you notice accounts receivable is consistently and significantly larger than accounts payable, you are financing your customers to a greater degree than your vendors are financing you.
The key to managing these costs is to align your customer and supplier payment terms, so you limit the amount of money tied up financing both.
Inventory Carrying Costs
A significant amount of your cash reserves may be tied up in financing inventory. Inventory carrying costs are the costs of storing and handling raw materials, unfinished products or finished inventory in your plants and warehouses.
The longer inventory sits around, the more cash is tied up. So, maintaining low inventory levels does improve cash flow. A good rule of thumb: If the inventory you carry on your balance sheet is much larger than your sales in a given year or business cycle, you may want to re-evaluate your inventory levels.
Equipment and Facilities Financing Costs
If you are in a capital-intensive industry that requires heavy machinery, specialized tools or expensive facilities, a big part of your cash may be tied up in financing these capital investments or capital equipment purchases, as they’re called on your balance sheet.
Capital outlays can vary tremendously by industry. For example, car manufacturing is capital intensive, requiring large investments in equipment to keep production going. Others, like consulting, rely on human capital.
Regardless of how capital intensive your industry may be, the secret to success is to make your capital work harder than your competitors with better productivity, capacity utilization and smarter financing.
This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.