Good Management Starts with Managing Working Capital
Cash is the heartbeat of every business. Every successful business needs to maintain the proper amount of cash to operate (pay its bills). Cash flow is managed by managing the working capital of the business.
What is Working Capital?
In accounting terms, working capital is the business’ current assets minus its current liabilities. The three main components of working capital are receivables, inventory and payables, including current portion of debt.
Why is Working Capital Important?
Too much cash tied up in the business’ working capital can restrict growth and other spending opportunities like spreading to a new market, research and development of a new product, new equipment spending or the pay down of debt. In today’s low interest rate environment it’s sometimes easier to borrow the money than to properly manage working capital, but as interest rates rise this becomes an increasing less favorable option. Higher interest rates results in higher interest expense, lower earnings and less available operating cash.
How to improve Working Capital?
In order to decrease the amount of cash that’s tied up in working capital, businesses need to pay attention to the three main components of working capital.
Receivables – The objective is to expedite the collections of receivables into cash. Possible solutions could be initiating a discount for quick payments, changing the sales commissions to one based on collections verses invoicing, tighter credit policies, and start or increase collection calls/emails with in-house personnel. Companies can also review their administrative procedures for billing and collections to eliminate inefficiencies.
Inventories – The objective is to have the optimal amount of inventory. If inventory is too low, the business will lose sales due to customers buying from competitors who have the inventory in stock. If inventory is too high, then the business is using cash inefficiently. There are many costs related to inventory including storage, insurance, security and obsolescence. The main component for the efficient management of inventory is an integrated computerized system that will determine optimal inventory needed and integrate up and down the supply chain to determine optimal reorder timing and quantities and to more quickly reveal theft.
In service businesses inventory is better known as WIP (work-in-process). WIP is the unbilled labor costs and direct expenses. The main tool to manage WIP is an integrated time and billing computerized system. Management needs to ensure that invoicing for services are being billed timely and the proper personnel are being efficiently utilized.
Payables – The objective is to strike a balance of maintaining cash by delaying vendor payments verses maintaining good relations with suppliers and creditors and a positive credit rating.
No magic formula exists for reducing working capital, but constantly utilizing best practices is essential to the health of your business. The Herbein team can train you on how to evaluate working capital and help you identify your strengths and weaknesses.
Reach out to your Herbein advisor for more information or email us at [email protected]