5 Tips To Optimize Your Working Capital

Working capital optimization is a critical focus for businesses today. According to The Hackett Group's 2023 Working Capital Survey, many companies are maintaining high levels of working capital on their balance sheets, indicating that some businesses might be missing out on profitable opportunities.

The 2023 survey revealed a decline in working capital metrics from 2021 to 2022. Notably, the cash conversion cycle—which measures the time taken to turn inventory purchases into cash from customers—increased by 3% during this period. Additionally, the days payables outstanding (DPO) ratio, which tracks the time from purchasing raw materials to paying suppliers, decreased by 8%. Factors contributing to less efficient working capital management include geopolitical instability, inflation, and supply chain disruptions.

If your working capital has increased over time, it may suggest inefficient management practices. Read on to discover some strategies to enhance your company's performance in 2024.

Working capital — current assets minus current liabilities — is traditionally a measure of liquidity. It answers questions such as: How fast can assets be converted to cash? Are there enough current assets to cover current obligations? In general, higher liquidity equates with lower risk.

But companies can have too much of a good thing. An alternative perspective on working capital is to compare it to total assets and annual revenue. From this perspective, working capital becomes a measure of operating efficiency. Excessive amounts of cash tied up in working capital may detract from other spending options, such as expanding to new markets, buying equipment and paying down debt.

No magic formula exists for working capital optimization, but ongoing due diligence is key. Effective management requires an assessment of the key components of working capital: cash, accounts receivable, inventory and accounts payable. Consider these five tips:

Does your company tend to stockpile cash? Excessive cash reserves encourage management to become complacent about working capital management. For example, if there's plenty of money in the bank, managers might be less hungry to collect receivables and less disciplined when ordering inventory.

When cash is generated through debt rather than improved operating cash flow, it's important for the borrower to earn a higher return on its assets than it's paying in interest. But those that employ sloppy working capital practices are unlikely to achieve adequate returns. Eventually, debt and interest payments can overwhelm a business.

When a business sells on credit, it effectively finances its customers' operations. Stale receivables — typically any balance over 45 or 60 days outstanding, depending on the industry — may be a red flag of impending financial distress.

Managing collections starts by honestly evaluating which items should be written off as bad debts. Then viable balances need to be "talked in the door" as soon as possible. Enhanced collections efforts might include early bird discounts, electronic invoices and collections-based sales compensation programs.

These individuals will be charged with approving and monitoring customer credit, sending out collections letters, and making phone calls for any invoices more than 30 days late. Alternatively, these tasks may be outsourced to agencies that specialize in collecting debts from customers. Some companies might even sell or "factor" receivables to a third party at a discount, typically 20% to 30% off the invoice amount.

Inventory represents a huge investment for manufacturers, distributors, retailers and contractors. But it can be difficult to track and value. Enhanced forecasting and data sharing with suppliers can reduce the need for safety stock and result in smarter ordering practices. Computerized technology — such as barcodes, radio frequency identification and enterprise resource planning tools — also improve inventory tracking and ordering practices.

Businesses shouldn't pay a bill the day it's received. Instead, they should extend terms as long as possible, without losing out on early bird discounts. If your company can extend its average days in payables from, say, 45 to 60 days, you "train" suppliers and vendors to accept the new terms, particularly if your company is a predictable, reliable payor.

Managers often prioritize the top and bottom lines of the income statement, such as revenue and earnings. However, the balance sheet also deserves close attention. Connect with CSH to explore strategies for optimizing working capital accounts, including accelerating cash inflows and postponing cash outflows.