Improving cash flow and optimizing working capital is possible with these three strategies.
Working capital, aka cash flow, is vital for a successful business. After all, without sufficient working capital, businesses can end up missing opportunities, wasting money and ultimately fading away.
But many companies struggling with cash flow may wrongly assume that the only way to remedy the situation is through borrowing via traditional loans and lines of credit. Although this can be a good solution, there are many other ways to optimize working capital before going further into debt.
Factors that affect working capital
There are key factors that have a direct impact on cash flow. As a business owner, these will be top of mind every day.
- Accounts receivable: Money coming into the business increases working capital, so you’ll want to speed up this process as much as possible.
- Accounts payable: Conversely, delaying outbound payments will keep cash in your business for longer.
- Inventory management: Businesses that sell physical goods must be careful to balance their inventory with cash flow. Having capital assets sitting in a warehouse limits cash to use elsewhere.
Three strategies that help optimize working capital
So, what can you do in each of these areas to increase working capital and cash flow?
It makes sense that the quicker you get paid, the more cash you will have on the books.
Begin by negotiating favorable payment terms with your clients, reducing the time they have to pay an invoice. As an SMB, you may find yourself lacking the leverage to achieve this when doing business with larger companies.
One option is to invoice customers upon shipping or receipt of goods, or as soon as a service has been performed, rather than waiting until month end.
You can get around this by adopting a real-time payment tool for your goods or services, which gives clients an easy way to pay as soon as you send the invoice. It can be as simple as adopting a system that uses payment links sent via email.
Also, look at the efficiency of your invoicing cycle. How many days does it take for an invoice to land with the client after it has been approved? If you can shorten this time you’ll receive payments sooner.
Related: Read the Cash Cycle Guide
If you’re in a position where you regularly have large amounts owing to you, you could look at invoice factoring. This gives you access to working capital for a small percentage of your accounts receivable based on the amount due on an invoice. Also known as ”accounts receivable financing,” you could be more easily approved for this solution than traditional business financing.
On the A/P side, businesses should look at increasing Days Payable Outstanding (DPO). This financial ratio shows how long it takes your company to pay invoices from suppliers, usually measured annually or quarterly. The higher your DPO, the better your cash flow since the amount you owe stays in your hands for longer.
Here’s how you can calculate DPO with a simple formula:
Days Payable Outstanding =
(Average Accounts Payable / Cost of Goods Sold)
x Number of Days in Accounting Period
One way to increase your DPO is to negotiate better payment terms, perhaps increasing from 30 to 60 days. But as mentioned above, it can be difficult for smaller enterprises to achieve this when dealing with larger corporations. Everybody wants the most favorable terms for themselves, and more often than not, the big guys win.
You may have better luck striking a deal with vendors or suppliers you have had a long-standing relationship with and who may agree to extend your payment terms. Depending on the supplier, you may also ask for longer payment terms if you purchase larger quantities. However, this will vary from supplier to supplier.
We can’t stress the importance of finding the right mix of inventory if you’re selling physical goods.
Buy too much stock up-front, and your assets will be tied up until it is sold. But buy too little, and you may lose out on sales or disappoint customers with longer than expected delivery times.
It may be worth investing in inventory management software, which lets you find that balance based on lead times, stock value and other factors.
There’s always a way to improve working capital
The strategies mentioned above don’t require you to compromise how your business operates — you just need to make slight adjustments to optimize for working capital and increase cash flow. By evaluating the current way you send and receive payments, including the systems you use to manage your inventory and accounting, you’ll improve your working capital and enable your business to grow the smart way.