For a small or medium-size enterprise, being sufficiently busy does not necessarily imply having adequate money in the bank.
It may be the case that the company has sufficient sales, regular clientele, and an increasing number of orders, yet it is still not able to settle its payments to the suppliers, employees, landlord, or any other operational expenses. And it is the lack of one single component that causes these problems – working capital.
Working capital is an amount of money necessary for an enterprise to conduct all of its operational activities before receiving the payment from the clients. As soon as the time it takes for the customers to pay becomes greater than the time it takes for the company to pay its bills, the problem arises.
The more orders a company has, the more it spends for materials, labor costs, and delivery services before getting paid. Improved payment cycle is a solution to this issue.
What Is Working Capital?
Working capital is the amount of money that is available to the business to meet its short-term financial obligations.
In layman’s terms, it is the extra financial buffer that enables the business to stay in operation until money flows through the business.
The MSME will require working capital to fund the following:
- Costs of raw materials and stock
- Wages of employees
- Rent and utility costs
- Costs of logistics and transportation
- Payment to suppliers
- Sales and marketing activities
- Operational costs
A business having adequate working capital finds it easier to deal with these costs. A business that has insufficient working capital will find it hard to cope with the situation.
Why Working Capital Becomes a Challenge as MSMEs Grow
Indeed, growth can add more stress to the working capital position.
Consider the case of an MSME which is approached by a customer with a very big order. The MSME will be required to acquire more raw materials, employ more temporary labor, or produce more goods before making the delivery.
But the fact that the customer takes 60 days to pay for the services provided by the MSME, the MSME may have to wait for 2 months before receiving any money.
At the same time, the suppliers may require payment after 15 or 30 days.
Here we have a cash flow problem.
The Role of Payment Cycles in Cash Flow
The payment cycle is what dictates the rate at which money flows into and out of the firm.
As far as MSMEs are concerned, the goal is to ensure that there is equilibrium between receivables and payables.
If payments from customers are prompt and the firm maintains acceptable payment terms with its suppliers, then cash will stay longer within the firm.
Conversely, if customers fail to make payments promptly but suppliers insist on prompt payments, then there will always be a cash crunch in the firm.
How Better Payment Cycles Can Help MSMEs
Shortened Payment Cycle
There are various simple solutions to boost the working capital, one of which is decreasing the time gap between closing a deal and receiving payments.
MSMEs can specify payment terms before accepting the orders. The invoices need to be generated quickly and provide all relevant information to ensure that there is nothing stopping the customer from making the payment.
Additionally, there can be automatic reminders regarding payments which are due or approaching.
Decreasing the average time of receiving payment even by just a couple of days would make a great impact, especially for companies with a big volume of business.
Advance Payments
There is a possibility of advance payments to decrease the need for working capital for certain types of businesses.
Advance payment would allow MSME to start producing its product or service without having to spend its own money to pay for the production process.
Sometimes advance payment structure like 30% at the beginning of the deal and the rest on delivery works quite well.
Negotiation of Good Supplier Payment Terms
It’s not just the collection of payments which will enable effective working capital management.
MSMEs can negotiate good payment terms with their suppliers.
If the supplier gives 45 days’ credit for payment rather than immediate payment, then the business has more time to make money using the purchased goods/materials.
But businesses mustn’t try to unduly delay payments or cause trouble with their suppliers.
They need to negotiate payment terms which are beneficial for both.
Minimizing the Difference Between Receivables and Payables
An MSME needs to keep checking the customer payment terms and supplier payment terms. If customers pay in 60 days but the suppliers want payment in 15 days, then there is a huge cash flow difference.
MSMEs can work towards minimizing this cash flow difference by:
- Negotiating longer supplier credit terms
- Requiring advanced payments on big orders
- Follow-up of overdue payments.
- Negotiating reduced customer payment terms
- Offering discounts for early payments
Use Technology for Better Payment Cycle Management
Payment tracking through manual methods may prove challenging for MSMEs that grow bigger.
Tools such as digital accounting and invoicing software can assist firms in creating invoices, tracking overdue payments, sending reminders, and maintaining records.
Firms can also make use of dashboards to see which customers tend to pay later and which invoices are near their due dates.
Thus, the management of cash flow becomes proactive.
Firms do not have to learn about the absence of money only when the problem has already occurred.
Create Clear Credit Policies for Customers
Not all customers necessarily need to be treated the same in regards to their payment terms.
The MSMEs can evaluate customers on the basis of payment history, quantity ordered, relation, and creditworthiness.
In case of new customers, the company may decide to ask for an advance or partial payment until the company develops a good payment history.
Those customers who have a good payment history can enjoy more flexible terms.
A good credit policy will help in avoiding huge outstanding receivables.
Monitor Outstanding Payments Regularly
Unpaid invoices should not be regarded merely as an administration problem. Unpaid invoices have a direct impact on the financial well-being of the MSMEs.
Firms need to have an ageing account report that will help them categorize their unpaid invoices according to the time period during which they have gone unpaid.
For instance:
Current invoices
- 1-30 days past due
- 31-60 days past due
- 61-90 days past due
- Over 90 days past due
Better Payment Cycles Can Support Business Growth
Optimal working capital management offers MSMEs greater flexibility to explore their options.
With money on hand, the firm might be able to take advantage of purchasing inventory at optimal times, increasing orders, allocating funds to advertising, employing people, or penetrating into new markets.
However, firms that experience perpetual cash shortages are compelled to turn down lucrative prospects just because they lack funds to cover costs in advance.
Working capital in MSMEs is therefore linked directly to growth.
Cash management is not only about ensuring survival. It influences the ability of the firm to expand.
Common Payment Cycle Mistakes MSMEs Should Avoid
A number of common approaches may lead to working capital issues unnecessarily.
One is to offer extended credit terms without first determining whether it can handle this approach.
Another one is to delay invoice creation. In case the invoice is created after some days following the shipment, then the cycle of payments gets extended.
It is not advisable to rely only on verbal agreements of payment terms.
The last advice is that MSMEs should not use all cash on hand for growth purposes.
A Practical Approach to Improving Working Capital
MSMEs can begin by analyzing the present process of payments and ask themselves some simple questions:
How long do customers take to make the payment?
How fast do the businesses pay the suppliers?
What amount of cash is blocked in unpaid invoices?
Who are the clients who always delay payments?
Can advance payments be made on certain orders?
Is it possible to change the payment period with the suppliers?
This analysis can show where the problem lies and how to improve the situation.
Working capital is one of the most significant financial problems that MSMEs that are experiencing growth face. Good sales do not guarantee good cash flows when customers take time to pay.
Good payment cycles are what can enable firms to bridge the gap between cash flows and even manage their costs in a much easier manner.
MSMEs that want to improve their working capital management need to invoice customers timely, make sure that they receive payments quickly, negotiate realistic supplier terms, monitor their receivables, and use technology for their payments tracking.
The aim is not to just receive funds quickly or pay late. The aim is to have a financial cycle that will allow the money to flow in a smooth way.
Good payment cycles can enable MSMEs to transform their financial problem into a competitive advantage.
FAQs: Working Capital and Payment Cycles for MSMEs
Working capital is the money available to an MSME to manage short-term expenses such as raw materials, wages, rent, logistics, supplier payments, and other operational costs.
Payment cycles determine how quickly money comes into and leaves a business. Longer customer payment periods can create cash flow gaps when suppliers and employees need to be paid earlier.
MSMEs can improve payment cycles by setting clear payment terms, invoicing quickly, requesting advance payments, following up on overdue invoices, and negotiating suitable supplier credit terms.
Digital accounting and invoicing tools can help MSMEs create invoices, track overdue payments, send reminders, and monitor upcoming due dates more efficiently.
Yes. Better payment cycles can give MSMEs more available cash to purchase inventory, accept larger orders, invest in marketing, hire employees, and explore new markets.
