9 ways to improve working capital
Working capital is the lifeblood of a business. Here are nine of the best ways to improve your working capital position to fuel growth or build resilience.
Working capital – or current assets minus current liabilities – is an indicator of a business’s short-term liquidity. By improving working capital, businesses can ensure they’re able to meet financial obligations, maintain a steady flow of production, and generally keep operations running smoothly. Accordingly, strategies designed to improve a business’s working capital position can bolster operational health, enabling ongoing profitability, resilience, and competitiveness.
Effective working capital management – a process usually geared around improving working capital by freeing up cash trapped on the balance sheet or in inventory – is crucial in turbulent economic conditions. In EY’s CEO Outlook Pulse from January 2023, over half of the respondents said optimizing net working capital would be “very important” over the next six months.
As well as offering protection from external threats such as inflationary pressures or a state of global recession, working capital management can also allow businesses to prioritize investing in future growth. That makes it an undeniably important part of building a strong business.
Measuring working capital
Before discussing how to improve it, let’s first cover how to measure working capital. The standard calculation for working capital uses the following formula:
Current assets include cash and cash equivalents, accounts receivable, and inventory. Current liabilities include short-term loans, bank overdrafts, and accounts payable.
How to improve working capital
There are a huge number of ways to improve working capital. Working capital improvement techniques that are widely adopted because of their effectiveness, include:
1. Expedite accounts receivable collections
Accounts receivable represents money owed to a business but has yet to be collected. Accounts receivable are not yet assets – outstanding invoices only become revenue upon payment. Optimizing and streamlining the accounts receivable process can help to make this happen more quickly, resulting in improved working capital and decreased accounts receivable.
Many AR process optimization methods revolve around automation, which can reduce human error, increase data accuracy, and ensure that payment reminders are sent promptly. However, it’s also possible to make simpler changes, such as clearly defining AR policies internally and ensuring easy access to customer data through a centralized supplier management dashboard. These improvements can expedite collections by lessening confusion, reducing unnecessary delays, and speeding up the resolution of any disputes.
2. Slow accounts payable outflows
Working capital can also be improved by slowing down the release of accounts payable to creditors and suppliers. This can be achieved with improvements to the AP processes. By integrating automation in the AP department, businesses can improve visibility over outstanding bills. Focusing on building stronger supplier relationships and establishing better lines of communication can also help, making negotiating advantageous payment terms more likely and reducing disputes.
On another note, payment solutions like virtual cards can maximize the payment window: suppliers receive payment immediately, with the buyer paying later in line with the agreed payment terms. The more sophisticated virtual card solutions, like Taulia’s, include payment controls, cash analytics, and value-added tools.
3. Make use of working capital solutions
Two working capital solutions in particular – supply chain finance and accounts receivable financing – offer other ways to build a stronger working capital position, providing working capital boosts on both the payables and receivables side of transactions:
- Supply chain finance: Set up by the buyer – and based on the buyer’s credit rating – supply chain finance allows suppliers to receive early payment of their invoices, typically at a favorable cost of funding. The buyer pays the funder on the invoice due date, meaning that both buyers and suppliers benefit from working capital improvements.
- Accounts receivable financing: A line of credit backed by outstanding debt due to be received from customers, AR financing enables companies to free up cash trapped in their unpaid invoices. They can thereby boost working capital and make better use of their assets.
4. Manage inventory more efficiently
Different inventory management techniques can impact working capital position, too. For example, holding higher levels of safety stock can protect against future stock outages, but it comes at the cost of more working capital being tied up in inventory.
Leaner approaches to inventory management that seek to shorten the cash conversion cycle and preserve cash can maximize working capital. The just-in-time (JIT) inventory system, which receives materials only when production is scheduled to begin, is a prime example of this. However, these strategies require sophisticated processes and reliable suppliers. Even then, they can open businesses up to external risks.
5. Be more selective with your customer base
Customers can present various risks to a business. Some of the most damaging include the risk that customers default on payments, which can harm your working capital position or create bad debt.
This risk can be mitigated in various ways. Better credit checks in the onboarding process can be used to identify the riskiest customers, who can then be offered payment terms with less generous credit limits or required to provide payment upfront.
6. Improve cash forecasting accuracy
Cash flow forecasting enables companies to predict, analyze and address the factors that will affect their working capital in the future. By understanding seasonal and cyclical variations and macroeconomic events, businesses can make better-informed decisions on activities such as funding, investments, and capital expenditure. As a result, they can maximize the efficiency of their working capital in the short term while minimizing long-term risks.
Cash forecasting solutions provide near-real-time cash flow forecasts based on data from purchase orders, accounts payables, and receivables. They can also harness the power of machine learning, meaning the more data they receive, the more accurate they can make future cash forecasts.
7. Integrate automation
Outside of its uses in AR and AP process optimization, automation can help improve working capital in other ways. Most importantly, it can improve the accuracy and efficiency of processes and reduce costs over the long term.
A supplier management system that leverages automation, for example, can simplify the processes of supplier selection, onboarding, risk assessment, and contract negotiation. With more control over supplier data and documentation, companies can ensure that the products they receive are delivered on time and meet quality standards.
8. Limit unnecessary expenditure
Cost reduction is one of the most obvious ways a business can improve its working capital position. Although cutting costs indiscriminately across the board carries the risk of harming business operations, trimming expenditure selectively can be rewarding.
Low-hanging opportunities include leasing expensive equipment instead of buying it outright, which can help companies reduce their capital outlays. By strengthening access controls to payment systems, companies can also reduce maverick spend, whereby employees make purchases without following correct procurement processes. This reduces the risk of inefficient purchases and ensures that the company takes advantage of discounts that have already been negotiated.
9. Reduce or repackage debts
Finally, poorly managed debt can significantly impact the working capital available to the business each month.
Better debt management – such as seeking better interest rates and making sure that obligations are met on time – can reduce the long-term impact of debt, which can free up more working capital in the short term. In some cases, a business might consider paying down debt to reduce the overall cost of borrowing – although this comes at the expense of present working capital.