A company's ability to achieve its goals is greatly affected by how well it manages its working capital.
Free cash flow helps you accomplish goals such as funding growth, paying down debt or preparing for a sale. Every dollar left after paying for operating expenses and capital assets increases the value of a business as well.
"Tightening up your working capital capacity creates value. It's that value that gives you the ability to act on all the things in your strategy,” said Andy Rankin, head of commercial sales for SunTrust Treasury and Payment Solutions.
But many companies lack a cash strategy that dictates how they manage accounts payable, accounts receivable and inventory - or they do not follow the strategy.
Small businesses are often so busy growing or getting by that they do not consider how they manage working capital, while big companies tend to focus on bigger items like debt and equity. "A lot of companies started simply, grew rapidly and never stopped to think about what they were doing. It became an afterthought,” Rankin said. "But as you grow and get bigger, it needs to become a big part of your strategy.”
According to a report on working capital management by the National Center for the Middle Market, 75% of businesses are satisfied with their working capital management, but 41% have at least one working capital gap each year. Above average companies - as measured in terms of days receivables outstanding, current inventory levels, and days payables outstanding - manage working capital up to four times better than below-average peers.
A slight improvement in working capital management can free up large amounts of cash. "Unlike developing a product or launching in a new market to boost value, there is low financial risk in reviewing working capital management with the goal of finding improvements to free up additional cash for the company. Working capital efficiency is essentially additive to other strategic business initiatives already in place or planned,” according to a SunTrust whitepaper on unlocking hidden value through greater working capital efficiency.
Here are recommended ways to develop a cash strategy, benchmark its performance and create a cash culture that supports its success.
Develop a cash strategy
Rankin often gives business owners a restated copy of the company's financials that shows what their financial performance would have been had they improved or implemented their cash strategy sooner.
"These can be really meaningful numbers when you walk it down to how it affects valuation,” said Rankin, noting that improving working capital management could increase earnings before interest, taxes, depreciation and amortization by five to seven figures annually. "They're lacking an understanding of just how much value there is in this process if they do it.”
Rankin suggested the following best practices for improving working capital management.
Payables - "This is usually where companies have the most opportunity to improve. Even if they have a working capital strategy, they may not have a payments strategy,” Rankin said.
He recommends defining payment terms by payment method. For example, tell vendors they can receive a payment within 20 days with a card, within 45 days via ACH payment or 60 days if they pay with a check.
Receivables - "The more paper you can take out of the process, the cheaper you can make the process for both parties,” Rankin said. "If you can, work with customers on the front end to speed up receivables.'' Establish payment methods and terms within contracts when possible.
Inventory - Consider options like lean management or just-in -time inventory to ensure that your inventory levels match your sales volume.
"Any reduction in inventory will create additional free cash flow if your strategy shows that you have more than you need,” Rankin said.
Rankin also noted that eliminating paper in working capital management processes can help prevent fraud, like if you were to start making payments electronically instead of by check. "It can mitigate a significant amount of risk in the payment space in addition to creating value.''
You can gauge how much your business could improve its working capital management by comparing your company to peers in terms of key performance indicators like turnover for accounts payable, accounts receivable and inventory. The National Center for the Middle Market's Working Capital Benchmarking Tool offers one way for doing so, Rankin said.
SunTrust offers options for finding working capital benchmarks in its
whitepaper on increasing working capital efficiency: professionals who know your business, industry trade groups and professional organizations, government sources, and general business research.
The companies that manage their working capital best evaluate the
effectiveness of their cash strategy weekly or monthly, Rankin said.
Create a cash culture
Companies also manage their working capital more effectively when employees across the organization embrace the cash strategy. "This doesn't only apply to finance. Other parts of the company can directly impact the working capital,” Rankin said.
For example, if a salesperson signs a new client, the terms for how the company will be paid will be included in the contract. Similarly, an employee outside of the finance department could be paying bills sooner than the company's policies state.
"If you start educating people outside of finance on the value of speeding up one day in the receivables space or freeing up one day in the payables space, that creates a group of people that thinks like shareholders or owners,” Rankin said.
A cash strategy may not grab much attention on its own. But managing your working capital effectively does make achieving your goals easier.