working capital strategy

Working Capital Strategy

It is an oft-repeated phrase that “cash is king,” and effectively managing your business’s Working Capital can play an integral role in realizing this. After working with several small businesses, it is clear a key financial metric owners focus on is their Cash Balance in the Bank. Most realize their Cash Balance does not represent revenue growth, profit, or margin percentage, but it is likely a key metric used to give them peace of mind. The purpose of this article is not to downplay the importance of a company’s Cash Balance, but instead focus on why Cash Balances can fluctuate so much, how we can mitigate that, and how we can free up cash. The answer is Working Capital.

There are three components to Working Capital, which in aggregate give us the Cash Conversion Cycle (CCC). The CCC measures the duration, in days, of the lifecycle for an organization to buy materials, pay for materials, produce goods, deliver goods or services, and ultimately collect cash on their sales. The three components are as follows:

  1. Days Sales Outstanding (DSO): DSO is the average time it takes a business to collect cash from their customers after making a sale.
  2. Days Inventory Outstanding (DIO): DIO is the average time an organization holds their inventory.
  3. Days Payable Outstanding (DPO): DPO is the average time it takes for a company to pay their vendors.

As such, the formula is: DSO + DIO – DPO = CCC

To improve a company’s working capital position, the focus should be on decreasing the CCC. By doing so, a company can increase their available Cash Balance significantly. This can be achieved by decreasing DSO (Accounts Receivable) and DIO (Inventory), or increasing DPO (Accounts Payables). Think of it this way, the shorter time you hold your inventory or the faster your customers pay you, the higher your Cash Balance will be. Similarly, the longer you take to pay your vendors, the higher your Cash Balance will be.

Illustrative Case Study: Let’s assume Fulton Speakers Co. has the following information:

Sales:                           $6,000,000                   Cost of Goods Sold:    $4,000,000

Accounts Receivable:     $600,000                   DSO:                                   36 days

Inventory:                      $500,000                   DIO:                                    45 days

Accounts Payable:         $300,000                  DPO:                                    27 days

In this case, Fulton Speakers Co.’s CCC is 54 days: 36 + 45 – 27  = 54

If Fulton Speakers Co. made improvements to its Working Capital and reduced their CCC to 42 days, this would create an additional $180,000 of free cash on hand. While the excess cash will likely help the owners sleep better, it also allows businesses to:

  • Invest in Growth & Capital Expenditures
  • Hire more employees
  • Defer another round of financing, thus retaining more equity
  • Pay down existing debt or delay the need to take on additional debt
  • Increase valuation

There is always room for improvement in a company’s Working Capital strategy, regardless of the size or maturity of a company. This is particularly important for start-ups and small businesses as Working Capital Management is a lifeline and can make or break a business. As they say, “CASH IS KING!”

Here are a few simple strategies to improve the three components of Working Capital:

Accounts Receivable (Collections)

  • Early pay discounts
  • Accepting electronic payments: credit card, bank transfer, PayPal, etc.
  • Increased attention to Accounts Receivable Aging and efforts to collect

Inventory

  • Limiting bulk material orders to what is truly needed
  • Utilizing consignment inventory
  • Selling slow-moving inventory

Accounts Payable

  • Delaying payments to non-critical suppliers
  • Negotiating longer payment terms with vendors

Fulton Advisory has extensive experience in Working Capital Management and helping its clients improve their available Cash Balance. If you would like to talk to Fulton Advisory about your Working Capital strategy or other finance and accounting needs, please complete the contact form below so we can work together to help your business thrive!

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