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.
The Covid-19 pandemic has raised significant working capital challenges and uncertainties for organizations. Supply chain disruptions have been a major challenge, along with changing consumer demands and the collection of receivables.
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.
Working Capital management is particularly important since it is an accurate barometer for assessing the long-term financial health of a business and ensures that adequate cash flow is always maintained to meet its short-term commitments. In times of economic uncertainty, having such financial protection is vitally important. Managing working capital effectively should therefore be a top priority for CFOs, now, more so than ever.
First, let’s look at the key benefits of positive working capital for organizations. We will then delve into some of the working capital trends emerging from 2020 before highlighting 4 keys tips for managing working capital in 2020 and 2021.
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 customer 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 payments received.
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 vendors 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 organization 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 is 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 2020
According to PWC’s Working Capital Report, only 8 out of 18 sectors have shown improvements in working capital between 2019 and 2020.
With many industries suffering from the effects of geographical areas moving in and out of varying levels of restrictions at different times, these figures could look very different next year, with even more industries seeing their performance deteriorate.
Organizations need to look at different ways in which they finance their working capital in order to reduce their exposure to unavoidable risks currently being presented by both customers and vendors, such as changing customer demands and disruptions to supply chains.
According to The Hackett Group’s 2020 Working Capital Survey, organizations have focused on the availability of corporate debt as a source of working capital for too long.
While cash on hand increased by 12% in 2019, much of this was based on easily accessible and affordable total debt. Debt reached 47% of revenue in 2019. Such a figure leaves companies far more susceptible to a downturn than they were during the 2007-2009 recession, where debt levels amounted to 35% of revenue.
The Hackett Group state that “by optimizing working capital performance, companies could reduce debt as a percentage of revenue by about 11%”.
PWC report that €1.36 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 $1.278 billion for US companies in the areas of inventory, accounts payable and accounts receivable. Inventories offer the biggest working capital opportunity, with 39% of total working capital tied up in this area.
With such working capital opportunities in mind, we have come up with a list of 4 tips for effectively managing your working capital during these economically challenging times.
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 is important to monitor what you buy, just as much as what you sell. The key challenge for companies is to establish optimum stock levels and avoid driving up costs for physical storage and insurance as well as wasting stock if it is time-sensitive. This can be done by promoting better communication and forecasting between departments.
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 is extremely important to control what is purchased. Investment in procurement automation can greatly boost working capital. A centralized procurement process where each purchase requires authorization helps to prevent maverick spend by ensuring that procurement staff 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). Extending DPO should no longer be considered a viable option, particularly with many vendors having been affected by the pandemic and therefore unlikely to offer the option.
Companies that pay on time develop better relationships with their vendors 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 level of working capital, but if you keep your vendors 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, organizations need 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 in order to eliminate inefficiencies that may be causing delays in sending invoices to your debtors. Such inefficiencies may include manual processing, lost invoices, and high volume of invoices to manage. Professional services firm, Deloitte recommends using accounts receivable technology to deliver invoices electronically in order to speed up billing and collection, and ultimately shorten the cash conversion cycle. It is also vital to ensure that invoices are accurate before they are sent to your debtors to avoid delays in payments. Maintaining an accurate debtor’s 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 enough working capital available 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 for chasing late-paying customers.
The Covid-19 pandemic has presented a number of working capital challenges for businesses across a range of industry sectors. Economic uncertainty will continue in 2021 and businesses must look at new ways to finance working capital in order to maintain operations. By focusing on inventory, payables, and receivables organizations will be best placed to maintain adequate cash flow and maintain short-term commitments in the months ahead.
If you would like to learn more about how to manage your working capital, you can download our whitepaper here.