A disruptive event like an economic recession or even seasonal fluctuations can expose a lack of agility in working capital. Regardless of the disruption, working capital efficiency can be important for businesses of all sizes.
Reducing your working capital cycle can unlock cash that can provide a lifeline during tough times and allow you to take advantage of new growth opportunities. Read on to learn about the importance of a short working capital cycle, as well as four methods that can improve your business’ working capital efficiency.
What Is the Working Capital Cycle?
The working capital cycle (WCC) is the time it takes your company to turn net working capital (assets – liabilities) into cash. If your business makes cars, your WCC would refer to the time it takes to turn the materials you buy into cars, then sell them and get paid.
The working capital cycle is usually expressed in days and can be calculated using the following formula:
WCC = inventory days + receivable days – payable days
Reducing your working capital cycle can unlock cash that can provide a lifeline during tough times and allow you to take advantage of new growth opportunities.
Inventory days, also known as 'days inventory outstanding,' represents the average number of days a company retains its inventory before selling it. Receivable days, also known as 'days sales outstanding,' measures the average number of days it takes a company to receive payment after making a sale. Payable days, also known as 'days payable outstanding,' denotes the average number of days a company takes to settle its bills with suppliers.
The exact components of the WCC formula can vary for different types of businesses. For example, service-based companies that don’t hold stock might not factor in inventory days.
Businesses generally aim for a short and efficient working capital cycle that brings cash in as quickly as possible.
Benefits of a Shorter Working Capital Cycle
A long working capital cycle means cash is tied up in your business, which could lead to missed growth opportunities. Say a fitness business wants to lease a new gym building and raises $15,000 to pay a deposit. While this deposit sounds promising, a competitor with a shorter working capital cycle – and thus more available cash – might be in a position to not only pay the deposit, but also cover three months’ rent upfront. Such liquidity can make the competitor a more attractive tenant.
Freeing up cash by reducing the working capital cycle can also help your business survive slow times. For example, seasonal businesses with shorter working capital cycles tend to have an advantage. They can maintain better liquidity, enabling them to weather the quiet times, even when revenues aren’t at their peak.
How to Reduce Working Capital Cycle
Business owners who want to reduce the working capital cycle should consider speeding up money coming into the company or slow down money going out. This can be achieved using four key strategies:
1. Negotiate better credit terms with suppliers
One way to keep cash in your account longer is to negotiate payment terms with suppliers. In a new supplier relationship, you might need to pay upfront or upon receipt of goods, but if you have a longstanding relationship with a supplier, and particularly if you’re buying in volume, you can consider asking for better terms. For instance, if you’ve built up trust, it can be worth asking to pay on 60-day terms rather than 30. However, it can be good to approach such negotiations carefully to make sure there’s a mutual benefit.
2. Reduce inventory cycles
Another way to improve working capital cycle is to consider looking at ways to get products or services to market more quickly. In other words, you can reduce the time your capital is tied up in non-cash current assets.
Take used car dealerships for example. They might have a car serviced, cleaned, and ready to sell, and then spend 14 days taking photographs and writing listings. If the business could reduce the time it takes to list every car by just four days, and therefore reduce the time to be paid for that car, the impact over a month or a year could substantially boost working capital efficiency.
3. Reduce inventory volume
Holding excess inventory not only ties up capital but also can lead to additional storage, insurance, or even obsolescence costs. To streamline your working capital cycle, it can be important to refine inventory management so there is less cash sitting around in the form of stock. Regularly analyzing sales data, forecasting demand, and adjusting order volumes appropriately can help make sure you’re only holding onto inventory that’s likely to be sold quickly.
Another approach is to consider 'sale or return' agreements with suppliers. These agreements allow businesses to return unsold goods to the supplier, ensuring cash isn’t unnecessarily locked up in unsold stock.
4. Collect cash from receivables faster
Perhaps the easiest way to reduce the working capital cycle is to reduce the time it takes customers to pay you. This could mean changing payment terms, but it’s wise to be cautious in this regard. For instance, if you’re in an industry where 60-day payment terms are the norm and you demand monthly payments or advance billing, customers might choose your competitors.
To balance this, you can consider matching the most favorable payment terms in your industry. Invoice factoring can be another option, in which a third party, typically a financial institution, pays you immediately for issued invoices. Once the client settles the invoice, the third party collects the amount due. This method incurs a fee, but it can ensure immediate cash flow, enabling businesses to focus on operations rather than financial maneuvering.
However, invoice factoring isn’t a viable option for all companies. For example, companies producing bespoke products with high upfront costs might face risks with this method, as a client could potentially cancel an order post-production, leaving the business vulnerable. Such companies might prefer to ask for payment upfront in order to boost working capital, making it easier to take advantage of benefits like bulk material purchasing at discounted rates.
The Takeaway
Optimizing the working capital cycle is a strategic move that can enhance business agility, free up cash, and unlock growth opportunities. Whether it’s through refining inventory management, adjusting payment terms, or leveraging financial mechanisms like invoice factoring, businesses have multiple avenues that can improve cash flow. By adopting these strategies, businesses can weather economic uncertainties as well as position themselves well for future opportunities.
A version of this article was originally published on October 18, 2022.
Photo: Getty Images
