How to Optimize Working Capital for Your Business

Oliver Lee
August 1, 2022
 Mins Read

It is an illusion that a company with sufficient assets and adequate profitability would have a satisfactory liquidity position. The ability of the firm to convert its assets to cash quickly would determine its liquidity strengths. This is one of the primary reasons why working capital management is essential.

Working capital refers to the difference between a company’s current assets and current liabilities. It is usually inferred through the current ratio and quick ratio. A ratio that is higher than 1 is considered to be good for the overall health of the company.

Working capital is the lifeblood of any business and is essential for the smooth operation of the business. In order to optimize working capital requirements, it is important to manage the relationship between a firm’s short-term assets and its short-term liabilities.

Importance of Optimizing Working Capital

  • According to PwC’s 2014 Annual Global Working Capital Survey, top working capital performers generate higher EBITDA (earnings before interest, taxes, depreciation, and amortization) and better cash from operations.
  • By optimizing working capital, companies can reduce stock/inventory and decrease replenishment times from suppliers. In the process, the firm’s liquidity would improve dramatically. For example, companies can reduce inventory by reducing product customization and doing away with inventories for spare parts.
  • Even small changes in days of working capital outstanding can have a dramatic impact on speeding up cash flows.
  • Minor improvements to receivables, payables, and inventory processes can result in significantly lower operating costs, improved cash flows, and better accuracy in forecasting cash.
  • Adequate working capital communicates that the company is performing well and that it has sound management. This earns the trust of external stakeholders and satisfies the expectations of investors and shareholders.
  • In order to continue on the expansion path, enterprises will require considerable extra cash. They could locate extensive reserves of cash within their own balance sheets through working capital management, and avoid having to pitch for additional external financing.

Ways to Optimize Working Capital

  • Reduction in Inventory:

To reduce inventory, a detailed analysis of production planning and orders should be done. Post this analysis and its findings, the business has a choice of means to reduce inventory:

  1. Improve the accuracy of demand forecasting.
  2. Tie demand and logistics. Introducing concepts like just in time (JIT) and vendor-managed inventories would facilitate this process.
  3. Redesign the production process so that production is demand-driven and non-value adding steps are removed.
  4. Reduce product complexity so that the production process becomes simpler and customization is reduced. Standardization of products and customization of products late in the production line would help reduce inventories.
  • Faster Receivables Collection:

Several companies are early payers and late collectors, making it a case of higher working capital. If the company is able to receive payments quickly, cash flows would be improved, and the need for working capital would be reduced. There are a few methods to optimize the Accounts Receivable process:

  1. Improve the invoicing cycle. Prompt invoicing after dispatch or service can help quicken the receivables process.
  2. Setting up payment reminders and reducing grace periods can help.
  3. Direct debiting in the case of big customers can have a significant impact.
  4. A revision in the payment terms and conditions (for receiving quicker payments) for the primary customer base would help in quickening receivables.
  5. The introduction of ‘advances’ and pre-payment options would aid in improving the working capital situation.
  • Lengthening of Payables Cycle:

Accounts Payable can be a drain on working capital management for a business. The AP process and cycle can be improved in the following ways:

  1. Renegotiations with suppliers would aid in the improvement of payment terms as well as payment timelines.
  2. Firms should avoid paying before the due date.
  3. Companies could make payments after the fulfillment of all obligations by the suppliers.
  4. It would be advisable to balance receivables and payables for a positive cash flow.
  • Improved Cash Inflow Management and Forecasting:

Basic practices of cash inflow management, such as leveraging the banking partner’s structures, tapping into the buffer cash reserves, and real-time cash reporting, will facilitate working capital management in the organization. Additionally, a rigorous and focused effort at forecasting cash receipts and payments should be implemented, which will mitigate the uncertainty of the business environment.

  • Creation of Measurement Metrics:

Working capital management requires the creation of an effective program that is communicated to all stakeholders within the organization. As part of this program, metrics should be designed to assess the achievement of goals and as a feedback mechanism. Analytics will also have a role to play in building working capital in the business.

Poorly defined processes, lengthy production lines, and lag in real-time data can lead to a significant decrease in working capital, affecting liquidity. That is the reason why the above process corrections are necessary. Optimizing working capital can enable companies to meet near-term cost pressures by improving liquidity while ensuring sustained operations in the long term.

Article by
Oliver Lee

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