A key responsibility of the finance function is to manage working capital and increase the speed at which it is converted into cash. This article offers suggestions as to how this can be achieved.
What is working capital? Working capital is defined as current assets minus current liabilities. Current in this context means assets that can be turned into cash, or liabilities that are due, within 12 months. Current assets are things like sales ledger receivables, stock on hand or cash, current liabilities are things like purchase ledger payables, accruals, tax liabilities or a bank overdraft.
Why is working capital management so important? Working capital is a short-term investment and therefore must be funded, so carrying too much stock for instance could be expensive. The opposite is also true, having insufficient stock or cash could mean lost sales. Therefore, keeping the right balance of working capital is a vital part of any finance function.
Inter-relationship between cash and working capital Although a current asset, cash stands alone within working capital, because when we are normally trying to reduce current assets (e.g. receivables or stock) we are looking to increase our cash balance!
Working capital management is therefore about increasing the speed with which it is converted into cash, whilst maintaining enough (but not too much!) to conduct business.
Here are the 6 ways to turn working capital into cash with examples from our experience:
1. Increase payables
Ensure that suppliers (or other payables) are not paid before they fall due. Systematically go through your supplier list to negotiate longer payment terms to ensure they are longer than your receivables terms. Carry out this task after the filing of the annual accounts as improved financials often result in improved terms.
2. Decrease stocks
Aim to order the right stock in the right quantities at the right time! Not easy but systems and processes can help. Ensure that product issues are resolved quickly and effectively. Try to shorten the manufacturing process and reduce the time between purchase and sale. Going forward negotiate good prices and make your proposition something the supplier cannot refuse!
3. Decrease receivables Credit control is a vital element of a finance function and chasing customers to pay on time is very important. Ensure invoices are generated quickly and trigger your debt collection procedure on overdues as early as possible. Retail businesses are fortunate to sell very little on credit terms, their cash comes in quickly either by cash or credit card. Perhaps your businesses can take a leaf out of their book by selling more via credit card, thus getting the cash quicker and with less risk. Consider invoice discounting as a way to get paid quicker.
4. Improve profit Ensure that profitability is considered in everything that you do. Whether this be by “right first time” or in buying stationery, profit should always be considered. So often have we seen the benefit of hard negotiated cost reductions drained away by inefficiencies in a business. Ensure that you have good management information and make strategic decisions based on the findings. Use budgets and variance analysis to focus managers on cost control.
5. Long term debt or equity investment (cash injection)
Either will improve current assets more than the current liabilities (debt due within a year) and hence increase working capital and cash. But would they be right for your business?
6. Match asset term with debt term
It is not a good idea to buy long term assets (e.g. vehicles and equipment) with short term working capital. Match the term of the debt with the expected life of the asset. e.g. if a fork lift will last 5 years, lease it over 5 years rather than buying outright with cash.
At Finance Interim we can review your working capital and can recommend, or implement, changes to improve cash and profitability. Contact us if you would like an informal chat about how we can help.