​Working Capital Optimization – 101

Cash flow is just as important as profit, and working capital management is a strategy to generate the cash flow needed for operations. This article defines working capital management and provides the details you need to optimize the process.

What is working capital management?

Working capital management is the process of generating sufficient current assets to pay current liabilities. Effective management allows a business to fund operations each month.

Current assets include cash and other assets that will be converted to cash within 12 months. Accounts receivable, inventory, and prepaid assets are current assets. Current liabilities must be paid in cash within 12 months, including accounts payable and the current portion of long-term debt.

Working capital management differs, depending on a company’s size and complexity.

• Enterprise businesses: These firms may have multiple subsidiaries, some operating in other countries. They operate global supply chains, manage complex payment terms, and transact business in foreign currencies. A small increase in available working capital can mean millions more available in cash.
• Medium-sized businesses: Companies that are growing, but not quite as complex as an enterprise firm. These businesses may need to improve forecasting, collect receivables faster, and negotiate better terms with suppliers.
• Small businesses: These firms often carry small cash balances and operate with limited amounts of capital. Cash flow is the key to survival. Each dollar invested in accounts receivable or inventory must be converted into cash quickly.
• Startups: Startup teams focus on speed and growing revenue, but cash can run out quickly without a disciplined approach to working capital. A startup needs to demonstrate effective working capital management to investors.

Every business needs tools to forecast working capital to fund business operations.

Why is working capital management crucial for business success?

Successful companies view working capital management as a strategy for business growth and profitability. Here are several reasons why:

• Liquidity: The business generates more than enough current assets tomeet short-term obligations. Strong liquidity reduces anxiety, and managers can spend time on other tasks that generate profits.
• Profitability: Use available cash to take advantage of vendor discounts. Reduce the need for short-term borrowing and higher interest costs. Both steps increase profitability.
• Growth: Generate excess cash to launch a new product line, open more locations, or to increase the marketing budget.
• Risk management: Financial downturns can disrupt company growth. Avoid the need for external financing during an economic slowdown, when cash inflows decline.
• Stakeholder confidence: Investors, creditors, suppliers, and regulators each evaluate a company’s financial health. A strong working capital balance increases stakeholder confidence in the business.

The largest balances on the balance sheet are the key components of working capital. Typically, they include:

• Cash and cash equivalents: Cash and short-term investments, including money market balances.
• Accounts receivable: Money you are owed by selling goods and services on credit.
• Inventory: Goods held for sale to customers. Inventory may be produced in-house or purchased from vendors.
• Accounts payable: Money owed to vendors and suppliers.

The goal is to convert accounts receivable and inventory balances into cash as quickly as possible. A larger cash position can be used to pay accounts payable and other short-term obligations on time. This is the foundation of working capital success.

Best practices for working capital solutions

Every business must put a comprehensive system in place to forecast working capital, monitor cash activity, and to quickly respond to cash shortages. Here are some specific strategies:

Accounts receivable

Start by automating invoicing and collections to speed up cash inflows and reduce errors. Provide a digital payment option with each invoice. Offer early payment discounts to accelerate cash inflows.

Create a formal process for collections. For example, email the client when an invoice is 30 days old, and call at 60 days. Don’t let unpaid invoices pile up.

Inventory

The key is to balance inventory spending with the need to fill customer orders. Take a close look at stock levels and reduce inventory for slow-moving items. Use technology to forecast demand and coordinate inventory spending with customer demand.

Accounts payable

Payable management also requires a balancing act. You need to pay vendors on time to maintain good relationships, but you also need to avoid paying before the due date.

As your business grows, use your buying power to negotiate lower prices and better payment terms. Don’t take discounts for early payment if your working capital runs low.

Cash flow management

You need a reliable cash management process to manage current assets and current liabilities. Include these components in your process:

• Forecasting and tracking: Use automation to forecast cash balances based on sales and spending projections. Track cash inflows and outflows daily, and adjust the forecast as factors change.
• Cash buffer: Build a cash buffer so you have enough cash if your forecast is off. A buffer will help you avoid the need for external financing if things don’t go as planned.
• Integrations: Integrate your bank, credit card, payroll, and payable activity into your cash flow management system. Integrations give you more information quickly, so you can make adjustments.
• Monitor turnover ratios: Create a dashboard that includes both accounts receivable turnover and inventory turnover ratios. These two accounts may be your biggest use of cash.

Improve cash management by monitoring other types of spending and reducing costs when appropriate.

Working capital vs cash flow management: what’s the difference?

Cash flow management focuses on the timing of cash inflows and outflows. For example, many companies use a cash flow rollforward to manage cash. Here’s the formula for a monthly cash flow rollforward:

• Beginning cash balance
• Add: Cash inflows (customer payments, gains on sale, etc.)
• Less: Cash outflows (payroll, inventory purchases, vendor payments)
• Equals: Ending cash balance

The ending cash balance for March is the beginning cash balance for April. Cash flow is the movement of money for a specific period (month, quarter, etc.)

Working capital, on the other hand, is current assets less current liabilities at a specific point in time.

Impact of working capital on business liquidity and solvency

Businesses must manage both liquidity and solvency.

As explained above, liquidity is the ability to generate more than enough current assets topay current liabilities. Solvency has a long-term focus. It refers to generating assets and converting them into cash over the long term.

Companies need solvency to pay for long-term initiatives, such as building a factory or starting a new product line. Long-term projects may require a combination of cash inflows from operations and external financing.

The goal is to fund long-term needs without taking on excessive debt or depleting operating cash flow.

Common challenges in working capital management

Businesses need proper planning and an investment in automation to manage working capital. Here are some common challenges:

• Lack of visibility on cash position: You must know exactly where you stand each day, and how the cash position differs from your forecast. Without timely information, you can experience a cash shortage.
• Organizational hurdles: Working capital is vital for business operations. Your entire team must understand the importance of working capital and carefully monitor cash use.
• Payment management: Your system must report the payment terms for each invoice, including discounts for early payment. Managers also need to know if vendors charge late fees or interest expenses on late payments.
• Poor communication: Information needs to be shared quickly among sales, procurement, and the accounting department. If a new client is 40 days late on paying the first invoice, for example, sales may need to stop accepting more business until the first invoice is paid.

Communication and timely information are the keys to managing working capital.

What are the benefits of effective working capital optimization?

When you optimize working capital, you improve your financial position. Firms are in a better position to take advantage of opportunities and grow the business.

You can increase cash inflows by generating more current assets to pay current liabilities. Increased working capital reduces the need to borrow and pay interest costs. You have more flexibility, which allows you to finance a business expansion.

More working capital means you can pay invoices on time and maintain strong vendor relationships. You spend less time scrambling to collect more cash, and you’re better positioned to ride out a business slowdown.

A strong working capital position also increases company value.

Key performance indicators (KPIs) for working capital management

Create a dashboard with these important KPIs, and use automation to quickly update each metric as factors change:

• Current ratio: (Current assets) / (current liabilities)
• Quick (acid test) ratio: (Current assets – inventory) / (current liabilities)
• Accounts receivable turnover ratio: (Net credit sales) / (average accounts receivable)
• Inventory turnover ratio: (Cost of goods sold) / (average inventory)
• Days sales outstanding: (Average accounts receivable / total credit sales) X (number of days in the period)

In this case, “average” refers to the (beginning period balance + ending period balance) divided by two.

Steps to implement working capital optimization

As discussed earlier, poor communication, manual tasks, and limited data visibility can disrupt working capital management. Use these steps to build a strategy and optimize working capital:

1. Assess your current process: Document how to manage working capital now, and how much of the process is automated. Also, determine any bottlenecks in your current system. What factors delay your decision-making process or provide incorrect data?
2. Remove silos: Ensure that accounting, sales, and procurement can share data quickly. The group should have access to the KPIs explained above and understand the importance of each metric.
3. Improve data visibility: Provide KPI dashboards to each stakeholder and automate the creation of real-time reports.
4. Automate other manual processes: Forecasting, accounts receivable, and accounts payable should be managed in an integrated software platform.
5. Continuously monitor and optimize: Track KPI trends and make note of any procedures that still create bottlenecks. Make changes to optimize working capital.

Ensure that your team understands each step and buys into the long-term benefits of working capital management.

What are your working capital financing options?

Working capital optimization may not be enough to fund operations. Ultimately, many companies need additional capital. Here are the pros and cons of some common financing options:

• Invoice Finance (Factoring/Discounting): Borrowers can get immediate cash using receivable balances, but must pay fees.
• Asset-Based Lending (ABL): Businesses can leverage receivable or inventory balances to secure financing. ABL is not suitable for firms that don’t have a consistent asset base.
• Revolving Credit Facilities & Overdrafts: This option provides flexible access to funds, but interest rates are high and may increase with market conditions.
• Supply Chain Finance: This method can improve supplier relationships. However, this option requires a high level of supplier participation.
• Merchant Cash Advance (MCA): This is one of the fastest ways to get financing, but the cost of capital is high.
• Short-Term Business Loans: These loans can be approved quickly if you qualify. Businesses with inconsistent cash flow may not be approved.
• Trade Credit: This is a financing tool that extends payment timelines. Keep in mind that supplier terms may be restrictive.
• Revenue-Based Financing: Financing can scale as your revenue grows, but this is not an option for companies with volatile revenue streams.

Businesses need to choose options based on their current and future needs, with adequate risk assessments for all options documented. Ideally, you should decide on one or two options before you need additional financing.

Contact SAP Taulia to optimize working capital and build a strong financial foundation.