Working capital is a common measure of a business’ overall health – it’s an indicator of whether a company is able to pay off its short-term liabilities or not. Here we provide information about the working capital cycle and how to manage elements of the cycle to improve working capital within a business.
Working capital is a measure of the cash tied up in the day-to-day running of a business. On one hand, it can be seen as a measure of liquidity and short-term financial health. More working capital may indicate that a business is easily able to meet its short-term financial obligations. On the other hand, working capital can be seen as a measure of efficiency. Lower levels of working capital may indicate that a company manages stock effectively and collects cash from its customers quickly. The right amount of working capital is different for each company.
When we look at how efficiently a company manages cash flow, working capital is calculated as: Debtors + Inventory – Creditors.
Increasing working capital, a net asset, needs to be funded by cash or debt and therefore reduces cash flow, while falling working capital increases cash flow. Another more broad definition of working capital is simply current assets less current liabilities. This measure is more often used to evaluate short-term financial health.
The working capital cycle is the amount of time it takes your business to generate cash. It measures the time between paying for goods supplied to you, how long they sit in inventory and the final receipt of cash to you from the sale.
Many companies try to keep the working capital cycle as short as possible as it increases the effectiveness of working capital. The longer the cycle, the longer a business is tying up capital without getting any returns.
The working capital cycle is important as a business with a short cycle usually has healthy cash flow, whereas a business with a long cycle is likely to have cash flow difficulties.
Understanding the elements of the working capital cycle within a business is therefore important in order to minimise this length and enable effective cash flow.
The working capital cycle, also called the cash conversion cycle, is calculated by adding together the average number of days a business takes to get paid by its customers with the average number of days it holds inventory and then subtracting the average number of days that a business takes to pay its suppliers.
The working capital cycle can be broken down into three segments and calculated from financial information which is shown below. If a business is able to identify the time taken in each of these stages then actions can be identified to try to reduce any inefficient stages of the process.
Pressure on cash flow is a key sign of a working capital cycle that requires improvement. Any business needs cash to operate successfully so if the working capital cycle is impacting on this then improvement is required.
Even if a business is not having cash flow problems there may still be room for improvement within the working capital cycle that may release cash and enable additional growth or investment.
If you see an unexplained reduction in cash flow then it may be worthwhile reviewing the working capital cycle to identify any inefficiencies that may have developed and put in place an action plan to improve this. Looking at this at regular intervals should help you make the most your working capital and alert you to trouble well before it strikes.
The consequences of poor credit control can include:
If a business sells goods or services on credit, it is important to have good credit control processes in place. A simple way of looking for improvements in the debtor’s cycle is to understand the reasons why customer invoices are overdue and developing an improvement plan to look at the underlying invoicing, collection and dispute management processes.
Tightening up invoicing procedures by improving the timeliness and increasing the frequency of invoice preparation is an easy first step. Clearly documenting contractual credit terms and the trigger point for raising an invoice as well as the method of invoicing (e.g. e-invoicing) and what is required by your customer to approve the invoice (e.g. purchase order number) will also help to speed up the process.
In addition, understanding the range of credit terms offered to customers across products and markets should identify potential opportunities to reduce or harmonise credit terms. Businesses can manage the growth of credit terms by agreeing standard terms for particular markets or products and any deviation or request for non-standard terms would require review and authorisation as part of the contract negotiation.
Segmenting and prioritising customers by size, importance or risk profile and implementing a series of proactive collection activities should help to reduce overdue invoices. This includes defining roles and responsibilities across sales, customer service and credit control to accelerate the resolution of any customer disputes.
Where companies have looked to improve working capital, activities have often concentrated on the management of supplier payments. This has included leveraging and consolidating spend and extending payment terms to improve the cash flow cycle.
As well as reviewing supplier terms, there are other activities that could help to manage supplier payments. It is important that this is managed in a way that doesn’t increase risk within the supply chain through impacting a supplier’s cash flow. Just delaying payments can be counterproductive to developing supplier relationships and pricing negotiations.
A review of contract compliance would ensure that payment terms detailed in the latest contracts are captured accurately in finance systems so payments are not made earlier than agreed terms. Determining causes for other early payments would highlight further areas to strengthen.
Invoice acceptance and payment processes are also areas that should be reviewed. Whilst the invoice date is often the traditional date on which the payment term starts, alternatives are the date the invoice, or the goods or service, was received. Further, where an invoice falls on a weekend or public holiday unless the underlying contract includes significant late penalty charges, businesses have benefitted from making payment on the next business day.
Reviewing the frequency of supplier payments may also improve cash flow and process efficiency. Payment processes have been modified over recent years to include bi-weekly, weekly, fortnightly and monthly payment runs where end-of-month payment terms are utilised. As suppliers want certainty with regard to payment, being transparent about the payment term and the payment calendar is important in developing closer working relationships.
Stock control involves creating a balance between the need to maintain stock levels in order to fulfil customer orders and the cost of this. Stock control can involve a number of activities that may enable a business to manage stock more effectively.
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