Cash flow. Two, simple four-letter words that can induce a business to survive and thrive or be the cause of oblivion. Cash flow is the lifeblood of a business; it is needed to run operations, pay employees, secure financing, and keep a business alive. According to research done by US Bank and cited on SCORE, small business counseling, 82% of businesses failures are due to cash flow mismanagement. Effective working capital management is a mark of a good business, but growing businesses and high sales will strain cash flow and offset the balance of working capital. It’s a paradoxical challenge that a growing business causes increased expenses and a lack of working capital while cash is needed the most.
From small businesses to world-class enterprises, working capital is an important metric in assessing the long-term financial health of a business and ensures that adequate cash flow is available for short-term commitments. Effective working capital management will optimize the operating cycle, minimize the cost of working capital, and maximize the return on current asset investments. Working capital is simply measured by subtracting current liabilities from current assets with the net working capital formula or by calculating a percentage with the working capital ratio. Nonetheless, best working capital management practices include a multitude of narrowing formulas to measure working capital performance.
While working capital is an easy concept, there are any depths in which a business can measure and manage working capital throughout various company activities. All business owners and entrepreneurs work towards balancing their current assets to liabilities and optimizing operational efficiency, but properly calculating and benchmarking the appropriate working capital metrics through all variables is an intricate task and requires expertise.
There are four key activities in working capital management: cash management, inventory management, accounts receivables, and accounts payables. Leveraging effective working capital management processes through each of these components can maximize cash flow, yield substantial returns, and reduce risks and costs.
Generally, a high level of working capital indicates a well-managed company with growth potential yielding improved liquidity, operational efficiency, and increased profits. A positive outcome of the net working capital calculation or a high working capital ratio of 1.2 to 2.0 indicates sufficient cash and other liquid assets to fund acquisitions, new product development, debt reduction, share buy-back programs, or other strategic initiatives.
5 Tips for improving working capital
1. Choose the right KPIs to measure and set target performance metrics
The driving factor in managing working capital within a company is to use key metrics to assess overall working capital health and performance. Competitive businesses measure working capital KPI’s quarterly or monthly, assess performance next to competitors and industry-leading organizations, utilize benchmarks, and set targets for efficient, higher working capital. While the majority of businesses claim to be satisfied with their working capital management approach, only 50% of mid-sized businesses use benchmarks to measure success, based on a survey from the National Center for the Middle Market. Working capital performance management works best when anchored in KPIs measure working capital operations through benchmarks providing guidance to cash flow improvements.
Businesses focusing on optimizing working capital should hone in on specific working capital metrics and achieve double-digit percentage increases. According to the survey, the working capital metrics that are considered most important are debt to equity ratios, operating cash flow KPI’s, and accounts receivables turnover (or DSO). Companies with well-managed working capital will also measure days payable outstanding (DPO) to track success with accounts payables and days inventory outstanding (DIO) to track inventory turnover.
Choosing the appropriate working capital metrics to analyze varies between industry sectors and targeted operational activities for improved working capital management. Individual businesses should intentionally track KPI’s that they are setting benchmarks for by looking into public competitors’ financial data and performance. However, all businesses should continually measure liquidity with the working capital ratio and the cash conversion cycle (CCC) on a monthly basis to monitor when working capital management operations require improvements.
2. Reduce inventory and increase inventory turnover
For middle-market firms that carry inventory, well-managed inventory management may be the most powerful leverage to working capital improvements. Achieving a higher net working capital calculation can be achieved by reducing slow-moving inventory, increasing the inventory turnover cycles, and avoiding stockpiling. Although inventory is considered an asset in the working capital formula, less inventory on the shelves equates to more freed up cash flow. Optimizing inventory through the lens of working capital includes inventory management processes and analyzing inventory performance metrics.
Enabling cash efficient production and operation techniques can be achieved by pull inventory methods such as the just-in-time strategic method of inventory management. This process entails ordering inventory as needed for production and customer sales instead of stocking up before. High performing companies understand the value of just-in-time inventory or similar, lean inventory/manufacturing, and are willing to only invest in inventory once the product is demanded to avoid tying up capital in excess inventory and reducing overstock risks. Applying these methods as well as utilizing inventory automation systems or e-procurement can greatly reduce costs and boost capital through hyper-efficient inventory management systems.
Utilizing the inventory turnover ratio or days inventory outstanding (DIO) metrics that reveal the average number of days a company holds its inventory before selling it will allow a company to better understand its inventory turnover. An analytical working capital management team will periodically measure turnover rates, compare it to industry competitors, and uncover opportunities to reduce their DIO that result in increased savings and working capital. Efficient inventory management can have a significant impact on accounts receivables, accounts payables, operations, and overall profitability and growth.
3. Convert to electronic payables and receivables
The conversion from paper to electronic transactions has transformed payment processes. Electronic payments are a well-known trend, but optimizing payables and receivables with automated processes is imperative to cash efficiency and accelerated cash conversion cycles. According to Global Newswire, middle-market businesses can save 75% or more when they automate their accounts payable processes. Electronic payables processes such as purchasing cards can offer working capital increases in a company’s AP. Automated payments and electronic payment processes can open the door to favorable capital conserving payment terms, savings on rebate structures, and significant cost reductions.
Utilizing accounts receivables technology to deliver invoices electronically can also potentially shorten the receivables period and the CCC. Electronic receivables will reduce manual processing, error, lost invoices, and will ensure proper management with reminders eliminating some timely inefficiencies.
4. Share financial information and engage employees
To create a corporate culture that supports effective working capital management, companies should be willing to share financial information with operations, finance, or purchasing staff members who directly impact working capital performance. Providing managers with financing statements such as daily working capital reports, budget and sales reports, AR and AP performance metrics, and inventory calculations and audits will create a cash culture by involving the staff in the working capital management process. Successful companies may give their employees incentives or compensation for KPI performance leading to more accountability and engaged commitment to improving working capital management.
To experience revenue growth might mean to make working capital management a top priority in a company. To achieve a company culture dedicated to effective working capital improvements, leaders should define their strategic approach with defined objectives and goals related to cash management, receivables, payables, and inventory. They should also continually share and monitor these goals with their staff with monthly meetings to analyze and discuss working capital key performance metrics. Top performing businesses set working capital measurable goals and timelines for expected accomplishments stabilizing effective working capital management within the company.
5. Receive adequate financing
Utilizing short-term business loans is the final tip on working capital better management. Receiving working capital financing to increase working capabilities is achieved by possessing enough liquidity to finance current operations without taking on excessive risk. By analyzing working capital KPI’s and determining working capital needs can direct a business to carefully selecting the right financing solution and adequate fund size for forecasted operational needs.
In addition to short-term business loans, a business may instead opt for financing fixed assets with a long-term loan to stabilize healthy cash flow. Using existing cash flow to pay suppliers or fulfill purchase orders can potentially earn strong relationships, secure discounts, and increase cash return on asset investments counteracting the paid interest. Another financing option recommended to free up current working capital would be to refinance an existing loan to earn lower debt payments with an extended loan term.
A common way to obtain adequate financing is through an alternative lender, who provides various types of working capital loans for short-term needs to cope with the rigors of working capital management. A forward projected business plan, long term efficiency, and good revenue generation can often afford a business with quick access to funding. Alternative financial institutions are leading the race for working capital loans since they developed products to cater to the needs of small and medium-sized businesses in a shorter amount of time compared to traditional banks. LQD Business Finance is an alternative lender who has created an underwriting process that is quick and supports a broad range of solutions for varying industries and capital needs.
In conclusion, a strategic approach to working capital management should include initiatives within inventory, accounts receivables, and accounts payables operating components. Whether a company utilizes working capital financing through an alternative lender or tightens up inventory operating activities, working capital strategies that involve performance metrics, benchmarks, and accountable people can drive a business to achieve long-term success. Working capital management improvements can generate more cash for a business, increase operational efficiency, and raise profitability and potential growth.