The key to the survival of any business is cash flow, because if cash does not flow into the business at an adequate rate to maintain the level of working capital, then the business will struggle to survive. The working capital is defined in terms of current or short-term assets (petty cash, cash in the current account, stock, work in progress, and cash owed to the business) minus the current liabilities (overdrafts, money owed to suppliers or other creditors, etc.). If there is not a positive difference between the two, then the business cannot pay its bills on time. If cash flow is poorly managed or if the rate of expansion outstrips the size of the working capital (a situation known as over-trading), then only the goodwill of the banks and the creditors will keep the business going. In reality, neither of those groups can afford to be philanthropic when faced with repeated late payments, which are a sure sign of a potential risk; well, perhaps a little philanthropy from the banking sector would not go amiss at times.
Any business that is planning to diversify or grow must first ensure that it has adequate working capital in place to facilitate the expansion, and second, that it has suitable systems in place to monitor and control its cash flow. Unless the business operates in a strictly cash environment, any expansion will require the giving of a higher volume of credit than is currently the case. Whilst corresponding increased credit can usually be obtained from its suppliers, there will always be a gap between the two, i.e. the cost of the added value, and the profit margin which the business must make. It is the added value part, the staff wages, the overhead costs, distribution expenses, etc., that the working capital must bridge until the goods or services are paid for, and the more that is sold, the more the funds that are needed to bridge the gap. Without the working capital to bridge this gap, the firm will end up over-trading, which apart from being illegal (in that it is trading insolvently because it cannot pay its creditors when due) is a straightforward recipe for disaster. Many highly profitable firms have gone under because they have attempted to expand faster than their working capital would allow, and have simply run out of money with which to operate the business on a day-to-day basis.
Main factors that influence cash flow
The net profit from trading (assuming of course that all debtors pay on time). As trading profits increase, they will increase the amount of working capital available, but equally, any losses will diminish working capital.
The sale of fixed assets will increase the cash available to run the business, but any corresponding or subsequent purchase of fixed assets will reduce that sum. When a vehicle is sold at the end of its practical working life, the residual value will be added to the working capital pot. However, any replacement vehicle (which will inevitably cost more on account of inflation over the intervening years) will probably result in a larger sum being taken out of the working capital pot, unless other financial provisions are made.
When a long-term loan is taken out (or any other long-term liability), the working capital pot is increased; however, any regular repayments of loan capital and interest will progressively diminish the available balance.
Injections of extra share capital will also increase the available working capital, but this receipt will again be counter-balanced by the payment of dividends to shareholders and the taxation of profits.
Receipts from investments (interest or dividends) will add to the pot, but these are also liable to taxation.
Changes in the average balance of debtors and creditors are major influences on the available working capital. Increased creditors (more credit from suppliers) and decreased debtors (faster payment by customers) will both improve the cash flow, whilst conversely, the reduction in creditors and any increase in debtors will worsen cash flow. The latter is one of the inevitable effects of any growth in trading.
Increased stockholding, which may be necessary in response to growth in demand, will reduce the amounts of cash available, but if stocks can be reduced, e.g. by switching to just-in-time deliveries by suppliers or by simply reducing the average levels of stocks held, then cash can be freed for other purposes.
Each one of the above aspects needs a definitive policy and careful management if the available working capital is to be optimized, because it is easy for any one of them to get out of control and to wreck the effects of careful cash management in the other areas. For example, the benefits of a tight credit control policy can easily be wiped out by the loss of available spare cash due to overstocking or by not making best use of available credit from suppliers.