A Guide to Working Capital Optimization

Working capital optimization is crucial for any business that wants to facilitate growth and build resilience against market volatility. By improving how working capital is managed, companies can unlock trapped cashflow, reduce external financing needs, and shift focus towards strategic expansion opportunities. This article will explain what working capital optimization entails, its key benefits, and practical steps businesses can take to put working capital to its highest and best use.

What is Working Capital Optimization?

Working capital refers to a company’s current assets minus its current liabilities. Optimizing working capital means maximizing the short-term liquidity available to fund business operations and growth. There are three key metrics that collectively indicate how well working capital is being managed:

Days Sales Outstanding (DSO) – The average number of days it takes to collect payment from customers after a sale has been made. Lower DSO indicates a more efficient collection process.

Days Payable Outstanding (DPO) – The average number of days a company takes to pay its invoices from suppliers and vendors. Higher DPO indicates the company is making best use of credit terms.

Days Inventory Outstanding (DIO) – The average number of days from procuring inventory to selling it. Lower DIO signals effective inventory management.

To calculate the working capital optimization cycle, add DSO and DIO together, then subtract DPO. The result reveals how many days on average working capital is trapped between outflows and inflows. Leading companies aim to minimize this cycle wherever possible.

Why Optimize Working Capital?

Optimizing the working capital cycle unlocks significant benefits:

Improves liquidity – More available cashflow means reduced need for external financing which saves on interest expense.

Supports growth – Freed up capital can be redirected towards expansion initiatives rather than getting trapped servicing debt obligations.

Strengthens resilience – A buffer of liquidity helps companies better weather periods of economic uncertainty.

When market conditions tighten access to credit, proactive management of working capital takes on heightened importance. The global financial crisis provided many lessons – companies with the most efficient cash conversion cycles enjoyed earnings growth 1.5x faster than peers over 2008-2011.

Steps to Optimize Working Capital

The process of optimizing working capital requires a holistic approach spanning credit, collections, purchasing, inventory management, disbursements, and treasury. Some key steps include:

1. Digitize processes – Accelerating digitization of things like order-to-cash, purchase-to-pay, and treasury delivers efficiency gains that compound over time. Solutions to explore include e-invoicing, online receivables portals, virtual card payments, and integrated payables.

2. Identify quick wins – Look for tactical opportunities already available to capture low hanging fruit. This may involve relaunching dormant supplier card programs, enrolling more customers in supply chain finance, or rationalizing slow-moving inventory.

3. Build a strategic roadmap – Conduct an analysis of future initiatives that can optimize working capital management. Potential areas to address include trade financing, dynamic discounting, inventory pooling, and cash forecasting enhancements.

4. Tighten collections – Reduce DSO by strengthening credit policies, automating dunning processes, accelerating dispute resolution, and incentivizing early customer payments.

5. Extend payables – Increase DPO through consolidated payments, supply-base rationalization, and negotiating extended vendor terms.

6. Improve inventory turns – Lower DIO via demand-driven planning, buffer stock optimization, and disciplined cycle counting procedures.

Optimizing Accounts Receivable

With over 50% of working capital typically trapped in receivables, this area warrants special attention. Leading practices to accelerate order-to-cash include:

• Process mapping to eliminate delays between delivery, invoicing, and payment posting
• Dynamic discounting to incentivize early customer payments
• Digital presentment of invoices to customer portals
• Outsourced collections to resolve past-due receivables
• Credit insurance and factoring to mitigate bad debt risk

Optimizing Accounts Payable

Strategic approaches for improving procure-to-pay efficiency include:

• Consolidating purchases with fewer suppliers to enhance bargaining power
• Negotiating extended payment terms in exchange for loyalty
• Using p-cards with 45-60 day grace periods to maximize float
• Processing invoices in batches on scheduled payment runs
• Taking discounts only when economically justified

Optimizing Inventory

Leading practices to minimize inventory carrying costs encompass:

• Demand sensing and predictive analytics to smooth production
• Drop shipping and cross-docking to lower safety stock
• VMI and consignment arrangements to shift burden upstream
• Integrated business planning and S&OP to align supply-demand
• Lean, just-in-time inventory management to reduce waste
  

The collective impact of these initiatives can profoundly improve a company’s working capital performance. One global manufacturer was able to generate $60 million in cost savings and $120 million in working capital improvements over just 24 months.

Key Takeaways

Working capital optimization is a complex undertaking that requires cross-functional coordination and an organization-wide focus on cashflow velocity. While the ingredients for success are well understood – digitization, automation, collaboration, discipline – the recipe will differ across industries and business models. Leaders must challenge entrenched practices and tailor optimization strategies to best fit their operating ecosystem. But the long-term rewards for getting working capital management right are game-changing. Unlocking trapped liquidity is like discovering a hidden goldmine that can be mined again and again.