Regardless of a company’s size or industry sector, working capital is an important metric in assessing the long-term financial health of the business. The level of working capital available to an organization can be measured by comparing its current assets against current liabilities. This tells the business the short-term, liquid assets remaining after short-term liabilities have been paid off.
Managing working capital effectively should be one of the CFO’s top priorities since it is an accurate barometer for assessing the long-term financial health of a business and ensures that the company always maintains adequate cash flow to meet its short-term commitments.
When not managed efficiently, however, companies often suffer from cash flow problems that significantly affect their ability to expand, improve processes or even operate their business. PWC’s annual global Working Capital Study highlights that working capital performance was at its lowest in 2016, however, there is now a glimmer of hope, with 11 out of 17 sectors having improved their working capital performance since then.
Collaboration and streamlined processes between procurement and accounts payable teams need to be implemented in order to ensure the organization’s procure-to-pay process is optimized from both the perspective of the buyer’s cash conversion cycle and also suppliers’ cash flow needs.
Generally, companies will strive to achieve a high level of working capital. Having a high level of working capital indicates a well-managed company with a greater potential for growth. There are also several benefits to having a high level of working capital including improved liquidity, operational efficiency, and increased profits.
Benefits of Positive Working Capital
By obtaining a consistently high level of working capital, organizations ensure that adequate cash levels are available for any potential upcoming opportunities or unanticipated scenarios. It also gives organizations more flexibility over how they run their operations which enables them to fulfill custom orders, expand and invest in new products at a faster rate.
Optimum use of working capital management evades any future hindrances in business operations. A ‘safety net’ is available to protect against lack of production or delays in payment of suppliers.
A high level of working capital is only achieved when areas including Accounts Payable and Receivable are operating efficiently. In order for both departments to operate in an efficient manner, they need to ensure that they pay their suppliers as per the agreed terms, which lead to the capturing of early payment discounts and increase the income of cash.
Achieving the Correct Level of Working Capital
In spite of the importance of consistently maintaining a high level of working capital, it is also important to understand that there is a level considered ‘too high’.
Having an extremely high level on an on-going basis can indicate that there is more money within the organizations than is needed – that cash is not being invested correctly or company growth is being neglected in favor of high liquidity.
The key is to consistently maintain positive working capital, but avoid reaching too high a level that leads to waste and inefficiency.
Before undertaking strategical changes to effectively manage your working capital, it’s worth taking a look at some current working capital trends in order to see where mistakes and gains have already been made.
The State of Working Capital in 2019
As mentioned, the PWC study shows that working capital performance is improving within certain sectors, however, the likes of the automotive and pharmaceutical sectors still have a lot of work to do.
For those industries that have significantly improved their working capital performance from the low of 2016, a previous reliance on debt has been abandoned, in favor of more sustainable working capital opportunities such as inventory, accounts payable and accounts receivable management.
According to the Hackett Group’s 2018 Working Capital Survey, debt levels rose to 51% last year compared to the 35% recorded pre-recession.
In 2019, however, PWC report that €1.3 trillion could be released from the balance sheets of global listed companies by addressing poor working capital performance.
Similarly, the Hackett Group note a total working capital opportunity of €1.1 billion for US companies in the areas of inventory, accounts payable and accounts receivable.
If we look at working capital performance by region, however, focusing on the top 2000 companies in the US and Europe, the US is lagging behind its European counterparts. 44% of US companies have reported improvements in working capital performance, compared to 57% in Europe.
With such trends and benefits of positive working capital in mind, we have come up with a list of 5 tips for effectively managing working capital.
Tips for Effectively Managing Working Capital
1. Manage procurement and inventory
Prudent inventory management is an important factor in making the most of your working capital. Excessive stocks can place a heavy burden on the cash resources of any business. On the other hand, insufficient stock can result in lost sales and damage to customer relations. When looking at inventory, it’s important to monitor what you buy, just as much as what you sell. The key challenge for companies is to establish optimum stock levels: promoting better communication between departments and forecasting demand are steps to take in order to prevent your company from holding unnecessary levels of stock. As well as driving up costs for physical storage and insurance, the stock may be wasted if it is time-sensitive.
If stock levels are unknown, then it is difficult to manage the optimum level and the company risks experiencing a loss in sales as a result of a shortfall in materials. Periodic inventory checks are useful in monitoring levels of different types of stock and alerting finance to any recurring overstock or understock issues.
It’s extremely important to control what’s purchased. Investing in procurement automation solutions can greatly boost working capital. Streamlining and centralizing the purchasing process enables a rigorous authorization process. This helps to prevent maverick spend by ensuring that procurement officers are only permitted to order approved products/services from preferred vendors.
2. Pay vendors on time
Enforcing payment discipline should be a key part of your payables process. Analysis of working capital levels shows that the biggest improvement comes from improved payables performance and reduced days payable outstanding (DPO). Companies that pay on time develop better relationships with their suppliers and are in a stronger position to negotiate better deals, payment terms and discounts. It seems like a counter-intuitive way of maintaining a steady working capital, but if you keep your suppliers happy, it could save you money in the long run when it comes to getting larger discounts for bulk buying, recurring orders and maximizing the credit period.
3. Improve the receivables process
In order to shorten the receivables period, the company needs to have a good collections system in place. One important aspect of working capital is to send out invoices as soon as possible. Companies should reassess invoicing processes to eliminate inefficiencies that may be causing delays in sending invoices to your debtors (manual processing, lost invoices, high volume of invoices to manage etc.). Professional services firm, Deloitte recommends using technology to deliver invoices electronically in order to speed up billing and collection, and ultimately shorten the cash conversion cycle. It’s also vital to ensure that invoices are accurate before they are sent to your debtors to avoid delays in getting paid. Maintaining an accurate debtors ledger ensures that you are on top of debtor collection dates and can send timely reminders to your customers regarding payment.
4. Manage debtors effectively
The best way to ensure you have working capital is to make sure money is coming in on time. Reassessing your contracts and credit terms with debtors may be necessary to make sure you are not giving debtors too big a window to pay for goods and services – as this may be impacting negatively on your own company’s cash flow. CFOs should review credit terms with company management to ensure that the level of credit being offered to debtors is appropriate for your company’s cash flow needs. To reduce bad debts, you should implement more rigorous credit checks and ensure that effective credit control procedures are in place to chase late-paying customers.
5. Make informed financing decisions
Working capital is interest-free with no conditions, making it the cheapest and fastest source of cash for a company. As both PWC and The Hackett Group present in their working capital studies, most firms have no need to rely on debt financing and instead should look for working capital opportunities within their balance sheets.
Prioritizing working capital allows companies to make strategic investment decision, which drives operational performance and efficiencies. Conversely, not having enough operating liquidity because assets are tied up in inventory or unpaid invoices can have a huge effect on cash flow.
The way to make sure that working capital is managed is to use key performance indicators (KPIs) all the way down the business to operational level. As you map out receivables and payables over time, include inventory metrics and KPIs such as days sales outstanding, days payables outstanding, and days inventory outstanding. Continuous monitoring of the metrics is crucial to maintaining a sound working capital management strategy.
Determining business requirements is the first step in deciding on the best way to fund working capital. Whether your business is starting out in its first few years, or whether it’s time to expand may require different financing solutions. As there are better-suited means of financing for different stages of your company’s lifecycle, it’s important to regularly discuss plans and requirements internally with the senior management team and with external financial providers so that you can carefully plan and assess your capital needs in accordance with the strategic objectives of the company.