As the last several years have proven, the economic climate is uncertain. While the cost of borrowing may be historically low at the moment, it is not always easy for private companies to access that capital.
In addition, the risk of rising interest and economic uncertainty make most business owners think twice about taking on additional debt. So how do you finance growth when faced with this uncertain environment? One solution is working capital. But you have to have that working capital first. Let’s talk about that.
Reducing working capital levels frees up cash to reinvest in the business without taking on extra debt. And these reductions do not need to come at the expense of customer service or top-line growth.
In fact, proper working capital management can actually improve relationships with your suppliers and customers, and increase margins.
The key to working capital improvement is taking a systematic and sustainable approach. Extending credit terms with vendors or instituting more aggressive collections practices with customers may drive short-term working capital improvements, but the long-term effects could be devastating. Instead, you are better to follow three simple steps: analyze, diagnose, implement.
Execution of these steps needs to be a joint effort. The Finance team cannot drive these changes on their own. The entire organization needs to commit to making the improvements. In the analyze phase, review your historical working capital trends. Are there peaks and valleys? What drives those fluctuations?
Based on this information, begin projecting your cash flow requirements for the upcoming three months. How accurate are your forecasts? What causes the variances? This should point you towards areas for improvement. Good decisions are driven by accurate and reliable information. This is an area that many private companies do not focus on enough.
In the diagnose phase, identify the root cause of your working capital issues. For example, if accounts receivable are an issue, the solution may lie with the sales staff. Perhaps they are being compensated based on revenue, without any consideration towards cash. This can drive the sales team to accept customers with weak credit, or negotiate unfavourable credit terms in return for closing a deal. These types of behaviours can easily be eliminated through changes to the incentive model.
The implement phase is where the rubber hits the road. Once the root causes have been identified, the organization needs to work together to make the necessary improvements.
For example, a company that is experiencing rapid growth may be tempted to build in “safety stock” to ensure that orders can be delivered to customers on time.
It is very easy for this excess inventory to grow out of control. Buyers purchase extra raw materials, production staff build to stock, sales staff overstate demand.
All of a sudden inventory has grown by 50 per cent to support sales growth of 15 per cent. Eliminating this extra inventory requires constant communication and coordination between purchasing, production and sales, but the payoff can be huge.
This cycle of working capital improvement is not a one-time project, it’s an iterative process. Ongoing analysis leads to the diagnoses of new issues and the implementation of new solutions. Each time the company goes through the cycle, more cash is freed up.
Before you know it, there are funds available to pay down debt, buy new equipment, or invest in other parts of the business. This ultimately leads to sustainable (and profitable) growth.