Cash flow is the lifeblood of any business. As a SME owner in Singapore, ensuring that your business has a healthy cash flow is a make or break. One crucial indicator of potential cash flow trouble is when your (Working Capital/Revenue) ratio is larger than your (Gross Margin/Revenue) ratio (don’t worry about these accounting terms first, we will explain them shortly). In simpler terms, this means your business is spending more on maintaining its operations than it is earning from its sales, which can lead to serious financial trouble. Let’s break this down in an easy-to-understand way and explore why it’s so important to act if you notice this red flag.
What Are Working Capital and Gross Margin?
Before we dive into the ratios, let’s clarify what working capital and gross margin are:
- Working Capital is the difference between your current assets (like cash, inventory, and accounts receivable) and your current liabilities (like accounts payable and short-term debts). It’s a measure of your company’s short-term financial health and its ability to cover its short-term obligations.
- Gross Margin: This is the difference between your revenue and the cost of goods sold (COGS). It represents the amount of money left over from sales after subtracting the cost of producing the goods or services sold. If you are in the service industry, your labour costs directly associated with producing the service is considered as COGS. For example: Management Consultants, Project Surveyor, Hair Stylist, etc.
Definition of Ratios
- Working Capital/Revenue Ratio: This ratio shows how much working capital you have compared to your revenue. A higher ratio indicates that a significant portion of your revenue is tied up in maintaining your day-to-day operations.
- Gross Margin/Revenue Ratio: This ratio indicates the portion of revenue that exceeds the cost of goods sold. A higher ratio means you are retaining more revenue after covering the direct costs associated with producing your products or services.
Case Study:
- Revenue = $1,097,231
- Cost of Goods Sold (COGS) = $354,866 + $30,937 + $31,408 = $417,211
*be sure to check for direct costs being unaccounted for so your Gross Margin is accurate – a wrong set of numbers will give you the wrong analysis.
- Gross Margin = $1,097,231 - $417,211 = $680,020
- Gross Margin/Revenue = $680,020/ $1,097,231 = 60%
- Current Assets = $290,550
- Current Liabilities = $35,081
- Working Capital = $290,550 - $35,081 = $255,469
- Working Capital/Revenue = $255,469/$1,097,231 = 20%
Since Working Capital/Revenue (20%) < Gross Margin/Revenue (60%), this gives us a few findings:
- You are managing your assets and liabilities well because a small portion of revenue is tied up in the day-to-day operations.
- Business is generating a healthy profit from its sales.
- Your business is generating sufficient cash flow from its operations and the excess cash can be used for growth, investing activities or as reserves during economic downturns.
- Your business is more resilient to any fluctuation in expenses or sales drops.
- Such numbers are attractive to investors because it shows strong profitability and efficient working capital management.
If Working Capital/Revenue (60%) > Gross Margin/Revenue (20%):
- Too much working capital is tied up is the day-to-day operations of the business.
- Business is not generating a healthy profit from its sales. (you can imagine how stressful this can be for trading businesses where margins are so thin such that any big drop in revenue can make the business vulnerable to cash flow issues)
- Your business has higher working capital requirements than your gross margin, indicating that your business might not be making enough cash flow from its operations, making it difficult to pay bills and employees in a timely manner.
- Possibility of serious liquidity issues if your revenue drops or expenses increases unexpectedly.
- This increases the need for cash flow and you might need to rely on business loans, which increases your debt burden and financial risk especially since your profitability is low and you are already struggling to pay for operational expenses.
Immediate Action Needed
If you notice that your working capital ratio is higher than your gross margin ratio, it’s crucial to take action. Here are some options for your consideration:
- Increase Your Gross Margin: Look for ways to either increase your prices or reduce your cost of goods sold. You may want to look at differentiating your product/service to justify a higher price or negotiate better prices with your suppliers or alternative suppliers.
- Lower Your Working Capital: Focus on speeding up receivables and delaying payables. Encourage faster payment from customers, possibly by adding an interest charge clause in your quotations and offering discounts for early payments. Negotiate longer payment terms with suppliers to give yourself more breathing room, especially with suppliers whom you have worked with for a long time.
- Lower Operating Expenses: Go through every single line item of your operating expenses and identify areas where you can cut costs, no matter how small. This might involve finding more cost-effective suppliers, reducing unnecessary expenses, or renegotiating contracts.
- Seek Professional Help: If you are struggling with your cash flow challenges, it may be beneficial to seek advice from financial experts who can provide tailored solutions to improve your situation. They can help you identify the root causes of your cash flow issues and develop a plan to address them.
Conclusion
As a business owner in Singapore, understanding and monitoring your cash flow is essential to the health and success of your business. By keeping an eye on key ratios like the Working Capital/Revenue and Gross Margin/Revenue ratios, you can identify potential cash flow issues early and take the necessary steps to address them. Remember, the sooner you act, the better positioned you will be to steer your business towards sustained growth and profitability.
Don’t wait until it’s too late. Take charge of your cash flow today!