The Effects of Seasonality on Working Capital
Every business needs working capital to cover daily operating expenses and meet short-term debt obligations. Getting enough working capital requires a constant influx of cash, which the business receives from sales revenues and accounts receivable receipts. Seasonality affects the influx of cash. While its effect is greater in some businesses than in others, it almost always has at least some effect on working capital.
Seasonality can cause consumer demand to surge and then drastically fall. This makes inventory cost management essential for controlling its overall effect. Preparing for a seasonal surge in demand means ordering additional inventory, often far in advance of the surge. This places a strain on existing working capital if current sales revenues and accounts receivable payments aren’t sufficient to cover the additional expense. In addition, over-ordering or incorrect demand forecasting leads to excess inventories when demand takes a fall.
Accounts receivable is another component in cash flow generation. During a seasonal sales dip accounts receivable may out of necessity become the main source of funding working capital requirements. Internal accounts receivable controls that reduce average days outstanding and establish procedures for collecting overdue payments are a major factor in determining the overall effect seasonality has on working capital. One consequence of insufficient accounts receivable receipts may be a need to factor some or all outstanding accounts. Factoring reduces the overall amount the business will collect as it amounts to selling accounts receivable to a third party for a fee of about 2 percent to 6 percent of the total due.
Effective cash management is just as important during a seasonal surge as it is when demand falls. A business can minimize the effect of seasonality with a year-round cash management policy that forecasts annual cash requirements and sets upper and lower limits for the amount of cash the business must keep on hand. If cash on hand exceeds the maximum limit, the business can invest the excess in easily accessible cash equivalent investments. Short-term financing is an option if despite effective forecasting and inventory and accounts receivable controls, minimum cash requirements fall during a dip in demand.
If a business fails to manage or manages its working capital ineffectively, it may become less profitable and in a worst case scenario may eventually fail. An effective working capital management plan is a combination of inventory, accounts receivable and cash management components that work together to ensure the business can meet its working capital requirements. Accurate inventory forecasting and exploring options such as just-in-time delivery can ensure the business has enough inventories on hand without draining working capital. Accounts receivable controls can encourage customers to fund working capital with timely payments and good cash management policies can reduce the need for short-term working capital financing.