Effective management of working capital is crucial for the success of any business. Yet, recent findings from The Hackett Group, a leading digital transformation and AI strategy consulting firm, reveal a concerning trend: businesses are not managing their working capital as efficiently as in the past.
The study shows a decline in all aspects of the cash conversion cycle (CCC), with an average increase of 1.3 days (or 4%) from 2022 to 2023. Sectors such as marine shipping, biotechnology, oil and gas, and food and staples retail have experienced the most significant deterioration. Understanding the importance of working capital and adopting strategies to counter this trend can help your business maintain financial health and operational efficiency.
Why Working Capital Is Crucial
Working capital is the difference between current assets and current liabilities. It’s essential for smooth business operations, but too much working capital can stifle growth and performance. The ideal amount of working capital varies by industry and the nature of your company’s operations.
Working capital management is commonly assessed by examining the CCC, which includes three key turnover ratios:
- Days Sales Outstanding (DSO): The average number of days it takes to collect receivables.
- Days Inventory Outstanding (DIO): The average number of days inventory remains before being sold.
- Days Payable Outstanding (DPO): The average number of days it takes to pay suppliers.
A positive CCC means your company needs to borrow or tie up capital while waiting for customer payments, whereas a negative CCC indicates that cash is received from customers before payment is due to suppliers. While cash businesses may have a low or negative CCC, most traditional businesses will have a positive CCC.
Strategies to Shorten Your CCC
Here are three effective methods to reduce the amount of working capital tied up in your business:
- Accelerate Receivables: Speed up the conversion of accounts receivable into cash by tightening credit policies, offering early payment discounts, incentivizing collections through bonuses, and using internal collection teams. Reviewing and streamlining administrative processes—such as invoice generation, dispute resolution, and deposit handling—can also help eliminate inefficiencies.
- Reduce Inventory Levels: Excess inventory incurs hidden costs like storage, obsolescence, insurance, and security. Utilize computerized inventory systems to forecast demand accurately, facilitate data sharing across the supply chain, and detect inventory discrepancies due to theft. In an inflationary environment, rising prices might inflate inventory values, so it’s crucial to manage inventory levels strategically.
- Extend Payables: By delaying payments to vendors, you can increase your cash reserves. However, be cautious: excessive delays can damage your credit rating or result in lost early payment discounts. Many companies have already negotiated extended payment terms with suppliers, so there might be limited room for further extension.
Make Working Capital a Priority
Focusing solely on revenue and profits can lead businesses to overlook the strategic importance of working capital. Benchmarking your company’s CCC against historical data and competitors can provide valuable insights.
At Accavallo & Company, LLC, our experts can assist in implementing strategies to enhance your working capital management without exposing your business to undue risk. Prioritizing working capital management will help ensure your business remains agile and competitive in a dynamic market.
