Effectively Managing Working Capital
Chris Morin, Senior Vice President, Scott Valley Bank

Working capital management is vital to running a successful company and should always be at the top of the list for any business’s management team. The challenging last few years has forced many companies to get back to the basics of generating cash to meet the many day-to-day financial obligations. The effective management of working capital is understanding what it is, the primary components involved, and then implementing policies and tracking to ensure sight is never lost again.

In simplest terms, working capital is the difference between a company’s current assets and current liabilities. Seeing the result of this equation provides little insight other than whether the position is positive (potential surplus cash) or negative (having potential liquidity issues). A closer and more in-depth examination of the position would be to focus on three specific balance sheet accounts -- Trade receivables, Inventory, and Trade payables -- and possibly the company’s cash conversion cycle* (how much time, in days, does it take to convert a dollar expended into the operation before it comes back in from a cash sale or collected via receivable due from customer). To be more proactive with working capital, management needs to review it regularly, such as weekly or monthly, and may set benchmarks for each component, e.g. maximum days to collect A/R is 55, or maximum cash cycle of 75 days. Benchmarks need to be realistic and based on experience as well as compared to industry standards. Once set, policies and procedures need to be defined and communicated to all the proper parties in the organization.

Companies with few policies and procedures focused on working capital, when the need for cash is important, simply start aggressively calling their customers for payment, delay making inventory purchases, and postpone making payments to suppliers/vendors. These kinds of reactionary efforts may generate quick cash, but this practice will not sustain a company’s operations long-term. Companies that handle working capital proactively usually have good accounting systems and reporting and set procedures that might include the following:

Accounts Receivable: 1) Concentrate on client base diversification; 2) Set good credit terms after a thorough due diligence and apply discounts, if necessary; 3) Address slow payers quickly and limit what is sold; 4) Require cash receipts to be posted immediately. This will ensure the A/R aging report is more accurate if it is the tool that is to be used for collection purposes; 5) Proactively call customers ahead of time to discuss any future orders and remind them about the open orders coming due for payment; 6) Immediately call for payments due and if beyond a certain amount of time, get upper management involved; 7) Provide financial incentives to those responsible for collections; and 8) For the contractors reading this, remember retentions are negotiable and should be addressed at time of contract.

Inventory: 1) Perform regular inventory counts; 2) Identify obsolete or slow moving inventory and sell at a discount; 3) Buy in bulk when possible and take advantage of discounts; 4) Seek out supplier relationships that can support a just-in-time inventory setup.

Accounts Payable: 1) Track invoices closely and prioritize the suppliers; 2) Maintaining the credit terms is, of course, ideal; however, when working capital is tight, be proactive and communicate with the key suppliers; 3) When answering vendor’s calls, make yourself available and provide friendly attention.

Adopting sound business practices, processes, and technologies that enhance the understanding of working capital management will have a positive impact on the company’s cash position and will determine future success in the years to come. Also remember that managing the above is about relationships, inside and outside the company; as such, proactive and effective communication is extremely important. If you believe the company needs help in the areas discussed, you should reach out to a trusted and qualified source, such as your banker or CPA. The Small Business Administration also offers, through SCORE, free classes to business owners that can help in these areas.

* The formula for the conversion cycle is Days Sales Outstanding (DSO) + Days Inventory outstanding (DIO) – Days Payables Outstanding (DPO).

Chris Morin, Senior Vice President
[email protected]
Scott Valley Bank - Santa Clara Office
View Scott Valley Bank - The Vault - October 2011