Working capital is the capital a business uses in its daily trading operations. It refers to the difference between a company’s current assets and its current liabilities. Working capital measures the company’s operational efficiency and its short-term health. In this article, we are looking at how to optimise and improve working capital.
Working capital is essential for companies as it is a daily necessity. Without working capital, a company would not be able to sustain its business, much less striving for profitability. In contrast, a strong working capital allows companies to meet business expenses even in times of financial instability. Therefore, working capital is one of the primary indications of a well-run company which companies should not neglect.
The working capital cycle
This cycle relates to the time a company requires for its net current assets and current liabilities to become cash. The working capital optimisation cycle focuses on 4 areas of a company: cash, receivables, payables, and inventory. By looking at how the company handles these 4 areas on a daily basis, we will be able to determine where is cash being tied up on the balance sheet.
How to Derive the Working Capital Cycle
The cycle equates to inventory turnover (in days) plus debtors turnover (in days) minus creditors turnover (in days). With a shorter working capital cycle, the company is able to free up its cash stuck in working capital. In contrast, a longer working capital cycle implies that the capital is locked in the operational cycle without yielding much return.
Thus, companies will prefer a shorter working capital cycle to improve their short-term liquidity condition and increase their operational efficiency. While the working capital cycle is subjective to different industries, it is beneficial for companies to compare themselves against their peers in the similar industry.
How to Optimise and Improve Working Capital
To improve working capital, most companies aim to shorten their working capital cycle by a faster collection of receivables, minimise inventory cycles and extend payment terms. Below are some of the tips that can shorten the working capital cycle.
1. Faster collection of receivables
Start getting paid faster by offering discounts to clients to reward their prompt payment. Also, centralising accounts receivable processing helps to maintain common practices and standards while automating processes reduces human entry errors.
Another viable alternative to reduce the average collection will be reducing the credit period given to its clients. However, for a company who wishes to prolong their own payment terms, its clients may negotiate similarly. Reducing the client’s credit period may jeopardise the good relationship a company has already established between its clients. This is particularly true if the company forces its clients to pay when they do not have the capability. At the very worse, the client might even stop doing businesses with the company.
The company should instead focus on its clients with the greatest ability to pay first to optimise its receivables. For public companies, publicly available financials such as annual reports will indicate the ability of the company for repayment. On the other hand, for private companies, credit rating data such as DP credit rating will be useful.
2. Minimise inventory cycles
Although inventory differs across industries, it is fundamental for every business to manage their inventory. Lean manufacturing to streamline the process of manufacturing and just-in-time (JIT) production are techniques to manage inventory. However, if the company tried to aggressively reduce its inventory turn-over, a large demand shock or a supply shock can lead to the inability to meet its current demand.
Although inventory forecasts are not absolutely foolproof, it acts as a good gauge to determine the optimal inventory cycle for each commodity. Moreover, the company can also brainstorm various ways to increase sales to decrease the time needed for inventory to become sales. With an earlier stock clearance, it would boost the working capital cycle.
3. Extend payment terms
If there is no discount for early payments that the company can take advantage of, the company will rather keep the cash for as long as possible to repay their debt. Better negotiations with debtors also help to prolong the payment terms. However, if the suppliers cannot keep up with the extended payment terms, this may sufficiently increase the company’s costs. This is because the suppliers will have to obtain financing at high rates and transfer the costs onto the company.
Improve working capital by optimising payment terms by filtering and negotiating with suppliers who can afford such payment extensions. This is to ensure that the company will not suffer from bearing the additional high financing costs.
However, in reality, many businesses cannot finance their operating cycle and are facing cash flow constraints. Instead of investing free capital in growth opportunities and greater shareholder payout, the company’s cash is tied up on the balance sheet. This shortfall can be mitigated either from retained earnings, loans or alternative financing.