Tips on Managing Working Capital for Growth
In my last article, I talked about why profit alone isn’t enough to grow companies and addressed the Cash Conversion Cycle (a.k.a. Cash Operating Cycle) and the importance of understanding it so you can manage it.
To dig in a little deeper, I’d like to crystalize the connection between cash and working capital. Two important financial goals in business are to:
1. make a profit, and
2. generate cash flow.
When these things aren’t occurring in your business, growth is nearly impossible. We all know what cash is in its purest form: actual physical currency or what’s in our bank account. Think of working capital as how cash is converted (i.e. flows) to other current assets (Inventory and Accounts Receivable). The flow looks like this:
Develop product or service => sell it => make a profit
Management of working capital is converting these non-cash assets back into cash quickly and efficiently.
For most businesses, the management of working capital is not a primary focus. The belief is that if I’m producing profit then I’ll have enough cash. I’m guessing many of you have lived or are living this myth. While profit is the best source of cash and working capital, it takes not only good profitability but also management of working capital on the balance sheet to ensure sufficient cash for growth. In some businesses it takes these things just to stay alive.
Let’s focus on the three components in the Cash Conversion Cycle:
- Accounts Receivable
- Accounts Payable
Let me walk you through a few tips that will show you how to focus on things you can control and improve upon internally.
Tips on Managing Your Inventory
We all know that the faster we turn our inventory the less cash we have to invest. Managing inventory feels more like an art than a science at times. Too much inventory ties up our cash….too little inventory will result in lost sales. Here are a few tips to manage your inventory:
- Forecast inventory requirements based on forecasted sales or sales history
- Factor in ordering lead time for receiving inventory
- Factor in safety stock to eliminate stock-outs
- Know your Profit Margin by stock item
- Delegate purchasing responsibility to a qualified manager
- Cycle count inventory
- Review inventory stock items regularly to eliminate slow turning low profit items
Tips on Managing Your Accounts Receivable
It’s important to remember that accounts receivable is the last step in the process before its converted back to cash. Not every sale is a good sale. If you loosen your credit to generate new sales and never collect some of your receivables, it has a two-fold effect on your working capital. One, it’s never collected (i.e. no cash), and two, you have lost your inventory. Profits only come from paid sales! Here are some tips on managing your accounts receivable:
- Establish good credit policies and processes
- Establish credit limits by customer
- Send invoices immediately – when orders are shipped or services are rendered
- Accept credit and/or debit cards
- Maintain a written collection of policies and processes – clearly identify accountability of team members
- Resolve customer service issues immediately that may impact invoice payment
- Consider e-Commerce sales with a merchant account (no accounts receivable)
Tips on Managing Your Accounts Payable
While our goal with accounts receivable is to collect faster, our goal with accounts payable is to pay slower within the terms of our agreement. Here are my tips for accounts payable management:
- Select vendors that will have a positive impact on your inventory management
- Ship complete orders on time
- Honor your purchase order pricing (i.e. negotiated prices)
- No partial payments of incomplete purchase orders
- Provide minimum 30 day notice of price increases
- Have more than one vendor for critical inventory items
- Written process for accounts payable approval and payment
- Do not pay invoices early
- Pay by check
Working Capital Strategies
All of the above tips are actions we can take and under our control. Here are a couple of additional strategies that will improve your working capital as well:
- Never use working capital to purchase long-term fixed assets. Long-term assets should be purchased using term loans or leasing.
- Consider re-financing existing fixed assets (equipment etc.)
- Obtain an equity injection from the owner or sell stock
This article has focused on things you can do internally to improve your working capital, and as you can see, there are many variables to consider. If you get stuck or have any questions, I’m just a phone call or an email away. Reach out to me any time by visiting www.cforickarthur.com/contact-us/. In my next article, I will address some external options for improving your working capital.