I’ve previously harped on about how working capital drives an investee’s value (see, Working Capital Series: Valuation). It receives this attention because it can affect value more than we often want to believe. Additionally, it’s not something that’s easily controlled; many external forces are at play (foreign exchange, shipping, terms, supply, demand, etc.)
But, with risks, we get areas for potential improvement. And, just as working capital can collapse a business, it can make a business thrive too (see, working capital profiles).
The primary drivers of working capital are the trade accounts: debtors, creditors and inventory. These accounts financially represent the trade cycle, which starts from the moment a customer commissions a product or service, to the moment all cash settles (inflows and outflows). Optimising working capital is really about optimising this trade cycle. This means ensuring your bottleneck is customer demand rather than your production cycle or payment terms.
One-off cash win #1: Payment Terms
When financial analysts think about improving working capital management, they immediately think of improving payment terms. This means getting your customers to pay sooner and your suppliers to accept payment later. Sometimes these are non-negotiable, but most of the time there’s potential movement. A particular area for improvement is on the supplier side, especially if they’re overseas. Most overseas suppliers will ask for a prepayment before they even ship the goods. But, if you can build trust and have them waive payment until the goods arrive at your local dock, this can lead to a monumental improvement.
One-off cash win #2: Inventory Management
It goes without saying that if you can sell the same amount and spend less on inventory, you’ll be better off. You can achieve this through streamlining any number of parts of your production and sales processes. You can also achieve this by rationalising your offering and reducing your number of SKUs (stock-keeping units). Overall, you need to find a balance between the inventory kept on hand and satisfying customer demand. Often it’s better to disappoint customers than to keep hundreds of slow-moving SKUs. Also, a great one-off cash win is to put your obsolete and slow-moving stock on sale, but make sure to keep your stock rationalised after you get rid of the dross.
One-off cash win #3: Operational Efficiency
When you optimise your payment terms (see #1), you’re bringing your inflows closer and pushing your outflows further. But, what does this really mean? Well, you may pay a supplier 60 days after you receive your raw materials and you may demands customers pay within 14 days of receipt of the finished product. But, there is still one major variable left: the time between receiving the raw material and shipping the finished product. This is where operational efficiency matters. You want to minimise this time to further optimise your cash cycle.
Operational efficiency deserves a few textbooks of its own, but for the purpose of this post, just consider what drives timing in your organisation. Often it’s people and process. Keep your people motivated and continually improve your processes and there’s no reason you shouldn’t excel in the area of operational efficiency.
Images: Good working capital management can make it rain money [source: Shutterstock]