What is working capital management and how can it be optimized?
Managing working capital is a balancing act between your immediate assets and liabilities. Get it wrong in one direction, and you may not have sufficient cash flow to pay your expenses. Get it wrong in another direction, and you could waste opportunities to utilize your additional cash flow.
Putting a working capital management system in place is often necessary, but it’s not sufficient to set-it-and-forget-it. If peak efficiency in cash flow management is the goal, you must continually monitor it and make changes as needed. These methods outlined below can help you formulate a plan for improvement.
What is working capital management?
In order to determine how to manage working capital, you should understand what “working capital” means. Simply put, working capital is the capital that you have immediately on hand to work with. It involves several components and processes. In a large corporation, the systems affecting working capital may represent several unique departments.
Managing working capital involves a detailed analysis of each of these processes as they relate to the company’s cash flow. A management strategy is a plan to improve the processes, streamlining the cash flow in a way that suits the business’s short-term and long-term goals. Determining the success of any strategy requires an analysis of the existing process compared to data from new attempts to make it more efficient.
Components of working capital management
The essentials of working capital management involve several aspects related to your business’s financial picture, including:
- Cash: Available cash to handle short-term expenses
- Accounts receivable: Incoming payments due from clients
- Accounts payable: Outgoing expenses to suppliers
- Financing: Access to additional funds, as well as increased liabilities to pay off any borrowing
- Assets and inventory: Inventory and supplies you have on hand
Effective working capital management requires not just keeping these elements in balance. Rather, you need to keep each one functioning in a system that allows you to minimize cash flow problems while providing opportunities for expansion. Maintaining your competitive advantage may require the company to make continual assessments and changes.
Ways to improve working capital management
Having a system for working capital management is only helpful if it is effective. You may need to isolate certain processes for improvement. Here are seven ways to improve working capital management:
1. Monitor your working capital ratio
Monitoring your working capital ratio allows you to determine how well your management strategy is working. The working capital ratio is a simple calculation. Divide your current assets by your current liabilities. If the number is higher than one, you have more liquid assets than you are currently using to cover costs. Ratios much higher than one may indicate that the company is not optimizing the use of excess cash flow. If the number is lower than one, you have less cash flow than you need to handle your short-term expenses. A ratio that is steadily decreasing could indicate a changing pattern that may make it more difficult to pay creditors on time.
2. Optimize invoice issuance process
Working capital management strategies start with income. If your business does not have an effective system to issue and track invoices, your cash flow may be unpredictable. Efficiency is a matter of course, making automated systems more timely and effective. The ability to issue an invoice using an automated process, especially one tied to delivery of a product or service, can significantly cut down on the days sales outstanding (DSO).
3. Incentivize receivables
The second step to reducing your DSO is to make client payment simple, quick, and required. Incentivizing receivables helps to create a predictable inflow of cash. Optimizing receivables might include the following:
- Vetting clients before opening an account
- Rewarding early payment
- Starting collections promptly for non-payment
A managed accounts receivables system can handle most or all of these processes on your company’s behalf. As an added benefit, your business can get higher accuracy in your invoicing and payment verification.
4. Automate business processes
Of all the benefits of working capital management, streamlining your business processes should rank near the top. Even the most modern of companies might still rely on human attention to process invoices, contact suppliers for payment, and more. AP automation software can decrease costs and improve accuracy, without having to rely as much on employee workflow. Once you have a system in place and functioning, you can track your metrics and focus on improving other aspects of cash flow.
5. Improve inventory management
Inventory management is a complicated system of tracking your company’s supply in relation to product sales. Businesses that do not have effective inventory management may have too much of their cash flow tied up in an asset that takes too long to sell, or insufficient supply to handle customer orders. An integrated system can make it easier to manage a just-in-time inventory, to ensure that client needs are met and free up cash for other uses.
6. Leverage supply chain financing
Supply chain financing often provides the best way to balance an inconsistent schedule between income and expenses. There are a variety of supply chain finance solutions to provide your business more time to handle supplier payments while you wait for receivables to come in. For a fee, you can have the benefit of paying on a regular timeline that fits with an optimized DSO.
7. Utilize tax incentives
Lowering overhead costs should involve a discussion of tax incentives. While your business likely takes advantage of various opportunities to lower your tax liability, you should evaluate whether you are maximizing it every year. Commonly overlooked deductions and credits may include:
- Temporary tax holidays for certain regions and industries
- Local and state tax incentives for businesses
- Accelerated depreciation for certain types of deductions
Looking for additional incentives each year and as your business changes can help to ensure that you minimize your tax burden as much as possible.
Corcentric improves your working capital management
Working capital management usually improves dramatically with automation. Relying on automated systems for tasks such as purchase order processing, invoice issuance, and inventory management — such as 3-way matching — helps to eliminate wasted time, delays, and errors related to human processing. Corcentric offers a full suite of solutions designed to streamline your processes for paying suppliers, receiving payments from clients, and more. These solutions reduce errors, increase receivable speed and accuracy, and improve cash flow.
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