Pay your bills, avoid bankruptcy: A guide to working capital for startups

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In its simplest sense, working capital means a company’s ability to pay for its dues when it comes due. This sounds super easy, but it’s actually one of the main reasons why a lot of companies end up bankrupt.

For startups especially, it’s a key pain point for those that deal with corporates, large businesses, and government entities, as it means dealing with their extended payment terms.

Managing working capital well can be helpful in at least two ways: it creates transparency in liquidity positions and it helps minimize the cost of short-term borrowings to fill the liquidity gap.

Liquidity

Liquidity means being able to pay for obligations as they come due. Managing a company’s liquidity position for a startup generally means the following:

• Quickly collecting cash from sales (receivable cycle)
• Delaying payment periods for the longest possible time (payable cycle)
• Facilitating the turnover of inventories (inventory cycle)

The above items are what finance guys would call the “cash conversion cycle.” The idea is simple, but execution is complex.

Faster cash is always good, right?

In an ideal world, yes. But doing business is much more complex than that. It’s a double-edged sword that you will need to handle carefully.

Being able to collect cash faster is good. If you sell your products on cash or credit card bases, the cash collection cycle is already fast enough. But for others, the cash collection period can be a lot longer than the agreed term of n/30 (30 days from the receipt of bill) due to poor leverage, follow-through, or record keeping.

To make cash collection faster, you could either shorten the payment period, follow-up more stringently, or offer discounts for cash payments. Whatever the choice, there will be a cost.

Shortening payment terms and intensifying collection follow-ups may alienate customers, as they are used to their current payment plans. New customers will also compare your terms against your competitors. And of course, large corporate customers would require much longer payment terms as they need to manage their own working capital.

Good thing for startups, innovative business models can tilt the cash collection process in their favor. An example is subscription models, where customers pay in advance at the start of each month.

How to measure

Should we just delay payments instead?

Do I really need to care about this?

I’m sold! What do I need to do?