Working capital optimization: How to master the cash conversion cycle

Cash flow is the lifeblood of any business. But constantly chasing after money — to the point of obsession — is far from the ideal way to grow a healthy small business. You need to be on top of it to stop worrying about it. 

This article explores the five best levers for managing working capital requirements. There are solutions to help you manage inventory as closely as possible, get paid quickly by your customers, and settle your own supplier debts without delay. 

It's all about optimizing the cash conversion cycle, with a view to growing your business.

Working capital requirement (WCR) definition

Before exploring ways of optimizing working capital requirements, it's important to remember how this financial concept works and what its purpose is. To go deeper, here’s a detailed guide to working capital requirements (WCR).

What is your working capital requirement?

This concept represents the cash flow required for the day-to-day running of a business. Before you can deliver to customers and collect the money from sales, you have to buy products or services from your suppliers. The time difference between incoming and outgoing payments is known as working capital requirements.

In most companies WCR is positive, meaning the company needs to bring money to fund activity. But in some business sectors, working capital is negative. In these cases, the company has surplus cash that it can invest in advertising or product development, or keep as profit.

Notion of cash conversion cycle and optimisation of WCR

Receivables and inventories are current assets, meaning they turn over. Other items replace stocks sold. New sales invoices replace those collected. The same applies to current liabilities, such as short-term operating debts.

Velocity matters here. The speed at which you replace assets depends on the speed of conversion. Until this process takes place — until you collect payments — cash remains unavailable. Also known as the cash conversion cycle (CCC), this process requires optimization in order to maximize your liquidity.

Why is it essential to optimize working capital requirements?

Cash flow is among the most important factors for SMB founders. Small adjustments to any one of the components of working capital — inventories, receivables or debts — help you find the cash you need to breathe and grow. 

In plenty of cases WCR management is the difference between companies that succeed and those that fail. Here are five ways to improve WCR management. 

#1 - Manage working capital with regular monitoring

How can you begin to manage working capital without knowing your requirements? Start by setting up regular working capital monitoring proportional to the company's turnover.

Calculate your working capital requirement and monitor its evolution

Include a small space in your accounting dashboard for the amount of WCR, and monitor its evolution over time. Include a graph with, for example, a curve to show how it fluctuates month over month. 

If possible, add the details of the calculation (its major components): trade receivables, stock, and outstanding suppliers invoices. This can be done with a simple account balance if you produce a monthly accounting statement.

Evaluate the evolution of the requirement in days of sales (normative WCR)

To forecast your financial resource requirements over the coming months, think in terms of a standard WCR — number of days' sales. This is because, mathematically, sales growth leads to an increase in WCR. 

To make this calculation, break down your approach by item: inventories, trade receivables and operating liabilities. If your supplies or sales mix change, take this into account when calculating the average time taken to pay suppliers or collect from customers.

#2 - Optimize the cash conversion cycle with careful inventory management

If there's one item on the balance sheet where money gets stuck, it's in inventory. Does your business need materials or goods available in advance? This calls for meticulous management, so as not to freeze cash unnecessarily or run the risk of stock-outs. 

You can also use one of the short-term financing options available on the market to buy your stocks. We discuss this in point #5 on outstanding suppliers.

Optimize your supply chain while avoiding stock-outs or over-stocking

Stocks on the assets side of the balance sheet involve paying suppliers of goods or raw materials, transporters, and employees for manufacturing. With a large stock, — more than you need — you’re living comfortably with little risk of running short. But you can find yourself financially strangled. 

How much should you order, and when, to avoid running out of stock? What minimum level should trigger restocking? Optimizing stocks requires rigorous monitoring of the entire supply chain.

Track overstocks and slow-moving inventory

By the same token, you must reduce waste in your inventory. Indicators such as stock turnover help to manage working capital. You can also analyze stock turnover in terms of days, item by item, using stock management software. 

You can then take action to sell off slow-moving products, or even dead stock, including through commercial trades.

Negotiate supplier financial terms for bulk purchases

Sometimes it pays to buy a lot, because you get a better price for high-volume orders. (The same goes for early payment discounts.) Do a quick risk-benefit analysis for this type of financial transaction and look for added value. 

At the very least, the discount on the price should help to finance any stock tied up in your warehouses. Otherwise that's money lying idle.

#3 - Reduce outstanding customer invoices for better operating cash flow

The volume of customer invoices awaiting payment can add up to a lot of cash. The faster your collections, the more this pile decreases, and so does your working capital requirement.

Optimize the order-to-cash chain (from order to payment)

Sales are good, efficient invoicing is essential, and actually collecting cash is best. Organize your administrative processes so that you can issue invoices quickly, based on clear orders and traceable deliveries. 

You should also ensure that your invoices are correct, with no errors and with the correct mandatory information. This reduces the risk of disputes. These good management practices encourage rapid validation and therefore faster payment.

Apply payment terms that are consistent with your business

Each company can define or negotiate customer payment terms (usually within legal limits). But one size doesn’t fit all. Make sure that your payment terms are not too long compared with those of your competitors, and that customers know their responsibilities up front.

Organize a regular and structured dunning procedure

Look at the totals in the aged trial balance of your accounts receivable. It breaks down outstanding invoices by tranche: not yet due, 15 days overdue, 30 days overdue, 60 days overdue, etc. This is a quick way of checking whether the company's dunning procedures are working properly.

Ideally, you want to increase pressure on customers as each successive reminder is sent out. It’s also essential to organize what comes next after the “friendly reminders” fail: legal action.

Encourage rapid collection of receivables: advance payments and discounts

To maximize working capital management of sales invoices, speed up the collection of sales by:

• Invoicing down payments on orders
• Granting a financial discount for cash payment or payment before the due date, which constitutes a price reduction for customers. (Same as you might receive from your own suppliers.)

#4 - Seek external financing for trade receivables 

Have you used all the levers available to reduce your outstanding trade receivables and therefore your working capital requirements? You can still improve working capital management and speed up the conversion of the cash cycle.

Look for a working capital financing solution for outstanding customer invoices

There are now a number of non-dilutive financing solutions for covering outstanding trade receivables. Banks, finance companies and factoring companies can finance trade receivables. These include discounting, factoring and assignment of Dailly receivables. 

In addition to these traditional financial solutions, there are new alternative or online financing methods. In these cases, the company uses outstanding customer receivables to access a cash advance before the invoice falls due.

How Defacto helps solve cash flow constraints

Are you short of the cash you need to embark on a new stage of growth? That's exactly what Defacto offers SMBs. We advance the cash flow that corresponds to your sales. This means you don't have to wait for customer receipts to buy back stock, for example. 

You can work straight away on the next phase of development. This is all the more important when demand is rising and you want to take advantage of hot opportunities.

#5 - Pay suppliers quickly to manage growth

As we explain in our guide to working capital loans, many businesses use supplier invoice financing.

Don’t delay supplier payments to reduce WCR

You may be tempted to pay your suppliers late. If you do this, you are in breach of agreed and even legal payment terms and risk penalties. Some countries even have name and shame portals (private or government-run) to out companies that consistently pay suppliers late. 

What's more, it's a sure way to damage supplier relationships. They will undoubtedly offer worse service, and eventually turn to other customers who pay on time and in full.

Meeting supplier deadlines leads directly to sales growth

Speeding up supplier payments increases your working capital requirements. That's true. But you're also working to build supplier loyalty and satisfaction. You appreciate prompt payment from your customers. Your suppliers expect exactly the same from you. 

By meeting their needs on time you avoid supply disruptions — a real handbrake on growth. You can be confident that supplies will meet your quality standards. You avoid having to place urgent orders with unknown suppliers.

Defacto's short-term financing solution for settling supplier debts without delay

We can also finance your supplier invoices when you don't have the cash to pay them quickly. With this type of credit, you maintain great supplier relationships and build long-lasting partnerships. In many cases, you’ll also get supplier discounts and better overall quality.

Managing WCR is an excellent practice for cash flow

These different approaches help to improve your company's cash position. For optimum working capital management, combine internal levers with short-term financing. 

Defacto provides you with a financial solution for both current assets and current liabilities: trade receivables, stock purchases or rapid payment of service providers.

Connect your finance tools and get financing in just a click. Use Defacto to check your eligibility and develop your business at your own pace.