There have been some huge lessons learned over the last two years in regard to supply chain management. In a pandemic that’s left us with transport delays, international shortages across supermarkets and manufacturing, some might say we’ve been in crisis.

Now, with a solid understanding of where it all went wrong, commercial teams across industries are poised to deliver significant changes in order to form an efficient supply chain. At its heart, this means that your company’s strategy also requires a focus on working capital optimization.

What is working capital?

Working capital refers to the liquid cash and assets that your company has access to at any time.

Calculated by subtracting current liabilities from current assets, working capital is effectively the ‘spare cash’ left in your profits that isn’t attributed towards operational costs. The cash tied to future payments and debts is money that cannot be used towards business development. So, managing and optimizing working capital is important.

Formula to calculate working capital

Working capital = liquid assets – liquid liabilities

Working capital is most often used to invest in business growth, or pay down short-term debt obligations. One of the most important factors in your company’s innovation, working capital has the ability to severely limit research and development.

Moreover, working capital optimization is key in getting ahead of your competitors. When you consistently have access to sufficient cash flow, innovation opportunities are endless. It is typically this R&D experimentation that leads to breakthroughs in the startup space, which gives you a valuable competitive advantage.

The goal is to have as much cash available as possible, ensuring stable cash flow – and working capital optimization should help you achieve this.

What is the working capital optimization cycle?

The working capital optimization cycle provides a look at how much working capital it takes to run your business.

Cycle = Days sales outstanding + days inventory outstanding – days payable outstanding.

This number varies based on your individual business and industry. However, you should review their working capital optimization cycle year over year to improve and stabilize.

Threats to working capital optimization

Most businesses experience common challenges when it comes to working capital optimization, and working capital management.

For example, good cash management can be difficult when companies are globally dispersed and reliant on multiple timelines. A delay in trading will lead to a delay in inventory fulfillment, which can have a knock-on effect on order frequency and risks running out of stock.

Some companies take on short-term debt to honour payment cycles when they owe suppliers or contractors and have not yet been paid themselves. This cycle is a threat to the working capital you have available, since it severely limits cash flow.

Finally, poor communication between teams and processes can lead to problems all the way through the supply chain. Without a clear system and consistent contact, it’s easy to become lost in the payments coming and going in your business. But without a spare pot for investment, your business risks stagnating and falling apart.

How to optimize working capital management

There is a range of solutions for working capital optimization. Most will require significant analysis and investment to increase liquidity and make operations smoother.

Of course, some working capital management solutions might be better suited to your business than others. So, here are some key steps you can take for an efficient working capital optimization program.

Inventory Management

Inventory management refers to the time it takes to sell your products once they enter your office.

Slow-moving inventory will become a huge problem for the balance sheet since it ties up your capital.

Moreover, poor management of inventory can lead to customer loss. In the case that your order frequency isn’t fast enough, customers are unlikely to wait around until the next shipment comes in – they’ll simply move to one of your competitors. Therefore, tracking inventory levels is important.

In order to get this management right, invest in automating the ordering and stocking process. Avoid running out of stock by using technology to prompt you when orders reach a certain point, for instance, 80% of capacity. This should help clean up your purchasing cycles.

Furthermore, prevent being stuck with a backlog of stock by analyzing your most popular products and tweaking quantities to fit buying trends.

Sales Management

Sales management refers to your accounts receivable.

  • Are you being paid on time by customers?
  • How long does it take to turn goods sold into cash conversion to maintain an optimal cash conversion cycle?

As a product-based business, it’s easy to request immediate payment from your customers. Unfortunately, service-based companies may find it harder to enforce immediate payment from clients, driving up the accounts receivable – the balance of money due to your business for goods or services you have delivered to customers but haven’t yet been paid for.

There are several moves you can make to optimize sales management. For starters, check the payment status of all customers in order to determine your current position. If you notice a large proportion of clients delaying their payment, you could:

  • be more proactive in both invoicing and collection
  • offer early payment incentives
  • offer a payment plan

By creating a payment plan or early payment incentives, you are effectively alleviating stress on the finance department by closing the gap between the initial sale and the funds entering your bank account. This enables more working capital availability.

Chasing up payments can be a whole project in itself. So it’s important to get efficient early on and determine who will be handling accounts receivables. In some cases, a focus on the contract terms might be the best action to take.

Days Payable

Days payable is the responsibility of the accounts payable department.

For instance, how long are you taking to pay your own invoices to suppliers and contractors?

If you can afford to extend payment terms with suppliers, you’re likely to have more liquidity in the business. By waiting longer to pay for services where the cost remains the same, you are more likely to have received the income from this time period already. It means that the team can better manage working capital optimization in this cycle.

You can’t simply change the contract terms without getting permission from suppliers – as this is likely to affect the entire supply chain management. To avoid legal issues, ensure you communicate overtly about any extensions in payment terms and consider the value of the account. In some cases, smaller payments are not able to be extended, whereas larger costs are.

Set up a working capital optimization team

Harness the power of a strategic, able team.

In order to ensure success, businesses should not just take into account their working capital goals and strategy, but also have an efficient team. The team that leads working capital optimization and management strategies should be across the benefits of a sustainable supply chain.

Internal stakeholders should include treasury to lead cash flow optimization, procurement teams for relationship management, accounts payable to help negotiate working arrangements with suppliers, and accounting teams.

While we can’t turn the clock on the pandemic, we can learn from the mistakes and create healthier balance sheets moving forward and having a stable working capital optimization program is the first step towards that. It takes entire supply chains to work together and build a better outcome for us all.

For further information, take a look at our funding options which aim to provide easy access to more working capital or chat with our team to learn more.