Daily Archives: August 29, 2013

Working Capital Optimization – The Basics

Working Capital Management is a managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. (Source: Investopedia)

Working Capital Optimization is optimizing the balance between assets and liabilities, and, since assets can’t generally be acquired or disposed of on a regular, or quick basis, generally focusses on optimizing the ratio of cash-on-hand (and liquid assets that can be converted into cash-on-hand within 90 days) to liabilities. In practice, most organizations attempt to accomplish this by optimizing receivable collection, inventory cycles, and supplier payment terms. In other words, they try to collect receivables faster, reduce inventory cycles, and extend payment terms.

These are all valid ways to optimize working capital, but if they are not undertaken correctly, supply chain costs will rise. If you force your customer to pay before they can afford to and the customer has to borrow to do so, that’s going to increase their cost to service their customer, and if their customer can’t pay, they are going to come after you for price reductions at contract renewal time, and that’s not good for anyone. If you try to reduce inventory turn-over too aggressively, you will end up doing a lot of expediting or LTL shipments, which will reduce overall acquisition costs in the long run. And if you extend payment terms beyond which your suppliers can afford, at the very least you risk increasing your costs substantially as they will have to borrow at high financing rates and pass that cost onto you and you may even risk their financial solvency.

So how do you optimize each of these areas?

  • Receivables Collection
    Go after slow customers, but focus on those with the most ability to pay first. For public companies, use publicly available financials to figure out who is cash rich. For private companies, use credit rating data, such as that provided by services like D&B.
  • Inventory Cycles
    Optimize inventory (carrying) costs versus logistics costs versus potential loss from stock-outs and determine the optimal inventory cycle for each commodity.
  • Payment Terms Extension
    As per Tuesday’s post, figure out which suppliers can afford payment extensions such that they would suffer no negative impact or where the overall supply chain cost that would be borne by the end consumer is lessened and extend the terms.