In the fast-paced world of small business, managing cash flow is often a delicate balancing act. Even if your business is profitable, excessive debt, rapid growth, or high owner draws can lead to cash shortages. Fortunately, there are clever strategies to optimize working capital and keep your business running smoothly. In this article, we’ll explore three effective tricks to boost your cash flow through working capital management.
What is Working Capital?
Working capital is the short-term cash you need to run the business. From an accounting perspective, working capital = current assets – current liabilities. An easier way to think of it is short-term uses of cash (like inventory and accounts receivable) minus short-term uses of obligations (like credit cards and accounts payable.) Less operating requirements = easier business to run. In fact, best-in-class companies often have negative working capital.
Here’s how to optimize your working capital to minimize cash requirements:.
Trick 1: Pre-Sell Goods or Services
One effective way to improve cash flow is by pre-selling goods or services. By securing payments upfront, you can access cash before delivering products or services. Here are some real-life examples:
Deposit Requirements: Boutique furniture stores require customers to pay a deposit when placing custom orders. This upfront payment helps cover material costs and provides working capital while the order is being fulfilled.
Membership Fees: Costco earns over 75% of their operating income from membership fees. That means they can sell their goods at nearly break-even margins but still turn a profit. Moreover, membership fees are paid before the member receives a single benefit (cost) from the company.
Reservation Payments: Airlines and hotels charge payment to reserve your service days or months before you need it. This practice not only secures revenue but also helps the companies plan staffing levels more effectively.
Downsides: pre-selling can scare away customers who are not ready to commit. This is especially true if your competitors offer a similar product or service without a presale requirement. Pre-selling can also lead to legal or regulatory issues if your business folds or cannot meet its promises.
Trick 2: Consignment Inventory
Another smart tactic to optimize working capital is by holding consignment inventory instead of purchasing outright. With consignment arrangements, you only pay for inventory once it’s sold, preserving cash flow in the meantime. Consider these examples:
Art Gallery: Instead of buying artwork upfront, an art gallery partners with local artists on a consignment basis. The gallery displays the artwork and only pays the artists once pieces are sold, reducing upfront costs and inventory risk.
Grocery Stores: Most large grocery stores pay suppliers when their products sell rather than when they stock the goods on the shelf. This improves cash flow and reduces spoilage risk.
Bookstore: A bookstore works with publishers to stock books on a consignment basis. By only paying for books after they’re sold, the bookstore maintains cash reserves for other business expenses.
Downsides: vendors hate consignment, and some may refuse to supply you under these terms. Vendors may not stock the best goods to you, instead trying to promote a new or slow-moving product. Vendors may not keep goods in-stock, so work closely with your suppliers to avoid these major customer disservices.
Trick 3: Convert Employees to Contractors
For service-based businesses with seasonal or cyclical demand, converting employees to contractors can be a strategic move to share volume risk and improve cash flow. Unlike employees, contractors are typically paid on a project basis upon delivery of services, rather than on a scheduled basis. Here’s how it works in practice:
Marketing Agency: A digital marketing agency struggles to keep all its staff busy due to fluctuating demand. They transition some of their technical specialists to freelance contractors. Although they pay the contractors a higher hourly rate, they save money during down periods when the contractors are not needed. By scaling labor costs based on project demand, the agency can better manage cash flow during slower periods while maintaining service quality.
Consulting Firm: A consulting firm hires subject matter experts as independent contractors on a project-by-project basis. The firm pays the sub-contractors only after the end-client pays, ensuring collections risk is passed through to all parties.
Downside: many individuals view contractor status as inferior to W2 employment and resent the conversion. Contractors are not obligated to provide you services and may be unavailable when you need them most. When they are available, you are legally not allowed to tell the subcontractor how to do their job, leaving you with poor quality control. Lastly, treating a contractor like an employee is illegal, so be sure you understand all the laws and regulations.
Cautions about working capital
Managing working capital effectively is essential for small businesses looking to optimize cash flow and sustain growth. But beware of the downsides each of these tricks creates and weigh them judiciously against your overall business strategy.
If you would like a professional opinion about your working capital structure, schedule a free consultation with our outsourced CFO.
This article was written by a CFOshare employee with assistance from generative AI for rhetoric, grammar, and editing. The ideas presented are a combination of the author’s expertise, original ideas, and industry best practices.
