Ensuring business survival by managing working capital
Many large firms from banks to manufacturers are investing heavily in technology and digital transformation.
Closure and loss of profits have become a reality for many companies in Kenya in the post-Covid-19 phase. As per the Business Pulse Survey, close to 65 per cent of Kenyan firms are still experiencing a decline in demand, cash flow, and available finance since 2020.
According to statistics, “In the period from July 2021 to February 2022, 1,365 companies closed operations in Kenya.” What leads to this situation? Most of these companies were lacking working capital and were probably on negative working capital with a lack of credit sources.
Working capital is the amount of investment made by the firm in its current assets to enable the smooth running of the business. A business does not run by merely investing in the purchase of large machinery and buildings.
It also needs to invest in raw materials to process through its machinery. The output produced requires time to be brought to the markets to be sold, and finally, the buyer also takes time in making payments.
Funds are required until this entire cycle is complete and since it is an ongoing process, these funds remain invested in the business till it is a going concern. A large part of these funds have to be provided by owners or borrowed from banks, but a small part of it also comes from the credit extended by suppliers for raw materials or other components of current liabilities.
Invest in technology
Many large firms from banks to manufacturers are investing heavily in technology and digital transformation. State-of-the-art technology will not be able to produce good financial results if it is not coupled with proper working capital management. Funds should be carefully handled in managing the day-to-day financial requirements of the firm.
A little bit of risk is also necessary for a business to be profitable. A low level of working capital is not a good business proposition either as this would mean struggling to meet the day-to-day expenses, and not being able to make payments to the business creditors on time.
Therefore, working capital should not be too large as it implies idle funds or overcapitalisation which means a lower rate of return, nor should it be so depleted that companies are unable to meet liabilities thereby running the risk of insolvency.
Several companies have over the years floated private bonds and some have defaulted on payment of interest and capital due to subsequent insolvency. Some firms have taken huge loans from banks, and at times they manage to secure unusually large loans from securities exchange-listed banks too, without providing adequate collateral to the banks and defaulting on payment to the peril of shareholders.
There are frequent news articles of companies, some unknown and others renowned, defaulting on debt and going under receivership leaving the creditors at their knees, trying to recover funds.
Perhaps issuers of large loans should request evidence of potential future liquidity status and working capital in addition to details of fixed assets as collateral before issuing large loans.
Working capital
What therefore should be the optimum working capital and how is it determined? One of the ways to calculate the current ratio is given by current assets divided by current liabilities. It is a reflection of working capital management. The current ratio is ideally 2:1 meaning current assets are twice as large as current liabilities.
The acid test ratio which should generally be 1:1 determines how many Shillings a business has available to pay each Shilling of bills it owes. It measures liquidity and a company's ability to pay its bills and other short-term obligations with short-term assets quickly convertible to cash.
However, the ideal ratio may vary from industry to industry.
Working capital cycle refers to the length of time between the firms paying cash for materials and other expenses entering into the production process, and the inflow of money from debtors. The determination of working capital cycle helps in the forecast, control, and management of working capital. Often, it is implicit when determining the value of a company. This is especially true when it involves mergers and acquisitions.
If the manufacturing process is longer, the requirement for working capital will be higher. Where liberal credit policy is followed, higher working capital is required as large amounts of funds are tied up in sundry debtors.
Similarly, if a company enjoys a good reputation in the market, it can get raw materials on credit and will require less working capital. When we have supply chain constraints such as those witnessed due to the Covid-19 pandemic, trade sanctions in certain regions owing to geo-political crises, and conflict such as the Russia-Ukraine war, the need for working capital in affected zones is definitely greater.
If the inventory is efficiently managed, less working capital is required however if improperly managed, excess purchases are made, requiring larger working capital to be available. If these inputs are procured internationally, the stability of the local currency should also be considered.
Currency exchange losses
On 1st January 2022, 1 US Dollar was trading at 113 Kenya Shillings. During the beginning of September 2022, 1 USD was trading at Sh120.35. Local manufacturers have faced currency exchange losses. If the raw materials are available throughout the year at constant prices. Inventory can be planned and less amount of working capital will be required but if supply in the market is erratic, large inventory may have to be purchased at times.
Those who make large advanced purchases may have storage and security costs to avoid theft, fraud, and deterioration of materials. Abnormal factors for example strikes, and lockouts, require more working capital. In recessionary conditions larger quantities of finished goods remain in stock, similarly, if there is inflation in the economy, larger amounts of working capital will be required for maintaining the same amount of current assets.
If competition is tough, the firm will have to give liberal credit to customers, and, therefore, investment in debtors will cause an increase in working capital. The stock of finished goods must be ready in the stores to be able to serve the customer as and when he demands the products.
The customer will not wait in a competitive market and the competitors will not leave any stone unturned to snatch away the firm’s loyal customers.
With higher tax rates and firms required to pay taxes in advance, more working capital is required. If the government demands more taxes in advance, more funds will be blocked in running the business and higher working capital will be required.
Where dividends are concerned, listed firms should ensure sufficient working capital to pay dividends to shareholders. It boils down to operational efficiency, poor management will require large working capital.
Ritesh Barot is a business and financial analyst [email protected]
