One of the key struggles for any startup is to manage its working capital. Working capital denotes all receivables/ assets which would convert into cash within a year (“current assets”) net of all liabilities/ payables which are to be settled in the same period (“current liabilities”).
Working capital is the life-blood of any business, and thus proper management of this should be a high priority for any startup CEO. Amazon, one of the best e-commerce success stories, is an excellent case study in managing working capital. Irrespective of making trading losses for most of its first 11 years of existence, Amazon has always generated healthy operating cash flows.
Amazon Inc Net Income and Operating Cash Flow for Past 4 Years
As is apparent, Amazon’s US$544B Market Cap has to be more driven by its Operating Cash Flow of US$16B (2016) then its meager net income of US$2.3B (2016).
Umpteen number of startups fail as the leadership team fails to understand the importance of working capital in business strategy. Often, they are focused on creating new products and customer experiences without appropriate financial rigor or discipline and run out of cash quite close to demonstrating product/market fit.
The following are few best practices which can be attempted to manage working capital in a fledgling enterprise better.
- Closely focus on Reconciliation and Settlement (‘R&S’) Process: If working capital is the lifeblood of an enterprise, the R&S System is the heart of that enterprise. It is not uncommon to observe that early stage enterprises can lose close to 5%-20% of invested capital due to an inefficient R&S process through leakages like excess vendor invoicing, under-invoicing of receivables, bad debts due to delayed follow-ups, undetected employee and customer frauds, etc.
The following are few best practices which can be attempted to better manage R&S Process:
a. Automate R&S Process: Best run startups across the globe have automated R&S Platforms which are interlinked with entity’s customer facing transaction platforms. While this sounds intuitive, it is surprising to note that most large Indian startups do not yet have this ready. Typically, in India, transaction reports are culled from the transaction platforms which are then manually reconciled with vendor and collection reports. Automated systems highlight anomalies in real-time and provide relevant collection/payment dashboards for the leadership to plan the next steps.
b. Maintain strong discipline: A robust R&S process has clearly defined rules which have to be adhered to. Whether it is a manual or an automated reconciliation process, it is advisable to perform reconciliation between entity’s transaction reports, vendor report and collection reports (from payment gateways/ banks/ courier companies) every working day. Any differences should be immediately highlighted for appropriate actions. Delays in performing this three-way reconciliation increases the risk of misappropriation, leakages, and losses on account of irreconcilable reconciliation differences.
c. Invest leadership equity in healthy R&S process: Fast growing tech-enabled startups always have more projects than engineers, so (supposedly) backend R&S process is always starved of tech bandwidth. The CEO/ Board should ensure that KPIs of the Executive team includes measurable goals with regards to the health of the R&S process so that they become equal stakeholders in guaranteeing optimal processes.
- Invest Organizational Bandwidth in Developing Short and Long-Term Cash Flow Forecast: A practical and realistic cash-flow forecast in which leadership has invested sufficient bandwidth goes a long way in managing working capital appropriately. The forecast gives a sense of direction to the entire organization. While some organizations do focus a lot on the yearly budgeting process, high growth enterprise also critically require short-term (weekly, monthly) cash flow forecast given that their growth rates and variables change very rapidly. Often, enterprises maintain their expense budgets even though they significantly lag on revenue growth causing a significant dent in the working capital. Important aspects to note while preparing this forecast is that along with planning routine cash inflows (collections for sales) and cash outflows (vendor payment, salaries, taxes), the forecast should also correctly reflect lumpy one-time payments (lease deposits, capex, ATL campaigns, yearly incentives, business acquisitions).
- Closely monitor payment and collection cycles: Best online businesses are those which collect in advance from customers and make vendor payment after some time lag. Few best practices for ensuring efficient payment cycles are as follows:
a. Control Trade Credit: If an enterprise provides trade credit to its customers, it should be via rigorous credit control mechanism. While striving for high growth rates, it is common for sales/ business development folks to ask for continuously higher credits for the customer. This strategy is fraught with significant risks and could sound a death knell for the business. The Board and the CEO should ensure that the organizational culture is set on sustainable growth drivers. The CEO should work with CFO on ensuring that a robust credit approval process is developed and communicated to the organization, exceptions to which should be approved only by them under specific circumstances. Once this policy is set, the Executive Team should spend time every week to review outstanding credit book. Apart from this, the field sales team’s incentives should be aligned with timely collection of outstanding credit.
b. Manage Trade Advances: Leadership should ensure that they don’t provide advance to any vendor unless that advance offers tangible and long-term sustainable benefits. Often, companies provide an advance for 1-2% additional discounts; this strategy is fraught with risks as it ignores time value of money and creates an expectation about future advance payments. The CEO or COO should approve a request for advance only when presented with a clear and a strong enough reason for making such an advance.
c. Negotiate with Payment Gateways: While negotiating with payment aggregators, banks and courier companies, typically enterprises ignore the settlement period. I have seen settlements done on T+7 days cycles as well. Debit cards and net-banking payment should be settled on T+1 days, credit cards on T+2 days, and courier companies on T+3/4 days.
d. Increase Trade Payables: An enterprise should negotiate for longer payment cycles with all vendors. It should be a KRA for the Head of Sourcing/ COO. Once negotiated, the enterprise should strive to make a settlement on invoice only on the due date as per the agreement.
e. Monitor Inventory Levels: For inventory driven business, inventory management is a critical component of working capital. Having too less inventory significantly impairs customer experience due to longer fulfillment cycle. On the other hand, higher inventory levels lead to blockage of working capital and increase risk of inventory obsolescence. Hence, inventory purchases should be “just in time” driven by use of analytics and data sciences. Additionally, the enterprise should conduct regular stock takes and implement strict controls over inventory obsolescence.
- Optimally utilize excess cash available in business: Balance in a current account does not earn interest for the enterprise. Hence, it is advisable to deploy excess working capital into liquid/ ultra-short term/ short term mutual funds based on cash flow forecasts. “Principal Protection” should the guiding principle for deploying excess working capital. Other factors to note for selecting mutual funds for deployment are:
a. Asset Under Management
b. Expense Ratio
c. Entry and exit loads
d. Historical Returns
e. Fund Objective
If the enterprise does not employ a treasury professional, then they can utilize services of a Wealth Management Firm to deploy surplus funds.
- Outsource what cannot be managed in-house
Often, due to growth and funding constraints, a startup is not appropriately staffed to manage working capital challenges. In such times, it is advisable to seek external help to manage critical and intensive processes like reconciliation-settlement and trade collections. Management should insist on timely dashboard from service providers to assess exposure and to ensure operating effectiveness of the processes.