Working capital is the subtraction of current liabilities from current assets. Current assets – Current liabilities = Working Capital
To put it out in simple words, Working capital is the money that you require for running day-to-day business operations. It includes placing an order, producing goods and services, stocking your goods and selling it to your customers. The most important thing here is that the money that you require should be with you at the right time, in the right quantity, in the right place which is working capital optimization.
If you ask as to why working capital optimization is important. It is because it brings with it numerous benefits which include, better liquidity, advantages over competitors, interruption-free production, improvement in credit profile, increased profitability. Working capital optimization also ensures higher return on capital and the readiness of shocks and peak demand.
The main aim of working capital optimization is to maintain a positive cash flow in the company. So in this article, we have mentioned the challenges faced by the companies with 10 ways to improve working capital and have given an overview of different tools that help in the optimization of working capital.
Challenges Faced by Business Owners
Your business will not run smoothly if you face all these challenges.
- Shortage of cash – Sometimes your cash is blocked somewhere or the other. So you don’t have it when you need it.
- Non-smooth business operations– Delayed in payment by customers.
- A high level of inventory- This leads to the risk of products being unsold and higher storage which automatically leads to more maintenance costs as well.
- Low profit– And all these factors directly affect your profitability rate
Now, let’s take a look at the tools that help in working capital optimization and also help you to overcome all the challenges mentioned above.
Learn more about – 3 Reasons Why Every Ambitious Small Business Should Hire Financial Advisor
Overview of Different Tools that Help in Working Capital Optimization of Businesses
1. Industry Growth Forecast
Sales forecasting plays a major role in the working capital optimization for businesses. It is basically forecasting the demand for the product first and then your potential to sell.
For example, if you are selling tea powder. First, you have to look at the demand for the product in the upcoming year for your product in your particular region or state. Only then you would understand the demand for your product and whether it will fetch you profit. It is important to understand the changes in consumer demand. You will get to know where exactly your industry is and get a better understanding of your consumers’ interests and preferences.
Here are the few things you have to keep in mind while determining the sales forecast –
- Change in consumer preference
- Trends in the past and future
- Seasonality in business
- Promotion tools and value-added services used
2. Inventory Management
Inventory management is basically keeping a note of all the purchases you have made, the total number of products that are up for sale, and maintaining stock. Inventory management helps in reducing costs and helps you in providing better customer service and satisfaction. You can use the 80-20 rule here. That is, 20% of your products will be responsible for 80% of your turnovers and the remaining 80% of your products will only generate approximately 20% of the turnover. Once you figure out the products that are responsible for 80% of your turnover you can manufacture more of them to attain more sales.
Learn more about – How To Manage Inventory? What Are LIFO And FIFO?
3. Receivable Management
Receivable management is basically ensuring your customers pay the bills for the products they have purchased on time. To maintain your working capital from running short of cash and funds, receivable management plays an important role. This keeps the liquidity intact and prevents risks. The main idea behind giving customers this payment option is to make your products available for everyone and build strong customer relationships which leads to more good deals and improves your company’s working capital as well.
When a company or a person buys a product from your company they are bound to pay you the due amount within the given time frame which is generally every month. As a company, it is your right to ask for the amount and if there’s a delay in the payment you must identify the reason behind the delay and offer help and solutions to your clients as well.
4. Cash Conversion Cycle
The cash conversion cycle is a metric that helps in approximately determining the time taken by your company to convert your investments in products into cash from sales.
The formula for calculating the approximate cash conversion period is –
Receivable days + Inventory days – Payable days = Cash Conversion cycle
- The Credit is given to customers = 180 days
- Stock held at warehouse = 30 days
- Credit received from suppliers = 60 days
So the cash conversion happens in 180+30-60 =150 days that is 5 months approximately.
This is how a cash conversion period is calculated. Now let’s look at the do’s and don’ts when it comes to working capital optimization for business.
The Do’s and Don’ts
- Create data of your customers
- Maintain real-time operational data
- Read/ use your P & L and Balance sheet statement
- Use software for more than just billing
- Fix your monthly withdrawal/salary.
- Use NEFT, Banking.
- Don’t use the company’s money for personal expenses.
- Rely on vendors or external credit periods.
- Extend high credit periods.
- Neglect timely collection of payment
- Overstock goods.
10 Ways to Improve Working Capital
A favorable working capital position is crucial for MSMEs and small business owners to function efficiently and effectively. Working capital refers to the money needed for day-to-day operations and is a sign of a business’s efficiency and its short-term financial health.
Explore the 10 ways to improve working capital for your business.
- Pay Vendors on time – Companies that pay on time develop better relationships with their suppliers and are in a stronger position to negotiate better deals, payment terms and discounts.
- Build Strong Purchase Process – Procurement process to necessarily include planning, budgeting & review, closely monitor unplanned purchases, adopt e-procurement processes, implement centralised purchase process or authority metrics in vendor selection, order approvals, etc.
- Improve Receivables process – The company needs to have a good collections system in place i.e. efficient invoicing system, Customer relations process, debtors aging system, payment follow up system, deter/disincentivize Bed Debts, etc.
- Manage Accounts Receivables effectively – To improve Debtors collection days, reassess contracts and credit terms with Customers/ Debtors.
- Effectively manage Inventory – Understand optimum stock levels, forecast demands, establish robust internal communication/ dataflow system to avoid miscommunication, incorrect decisions on inventory including overstock or understock issues.
- Evaluate Working Capital Financing options – Prudent to have a line of credit (e.g. Overdraft, Cash credit, etc.) from the bank to manage the short-term working capital shortfall. Also, avail Bill Discounting, Invoice Factoring and other transaction-based innovative financing options.
- Use Key Performance Indicators (KPIs) – Apply critical KPIs/ Ratios at all levels of business operations. Some of the key ratios directly related to working capital are:
- Days sales outstanding
- Days payables outstanding
- Days inventory outstanding
- Cash conversion cycle/ Operating cycle
- Make robust Plans/ Budgets and review the progress regularly – Determining business requirements is the first step in deciding on the best way to fund working capital.
- Think Working Capital impact as top of the list item while taking critical business decisions:
- To drives operational performance and efficiencies.
- To identify working capital opportunities within the balance sheet of the organisation and not just rely on debt financing or external money.
- Monitor Expenses – Analyse fixed and variable costs, monitor small expenses, bring Authority metrics for cost approvals.
If you want to know more about working capital optimization and need expert advice to increase your company’s turnover. Then, MSMEx can help you.
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MSMEx is an MSME business education platform where entrepreneurs and MSMEs can connect with sales, marketing, taxation, finance and fundraising experts. You can reach out for expert advisory & consultation or write us at firstname.lastname@example.org
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