Working Capital Management

Working capital management is key to a business’ survival. I have set out some simple information below to assist our clients understand what working capital is, why it should be managed and how working capital can be improved.

What is working capital?

Merriam-Webster Dictionary states working capital is a common measure of a company's liquidity, efficiency, and overall health. Because it includes cash, inventory, accounts receivable, accounts payable and current liabilities (within one year), a company's working capital reflects the results of company activities including inventory management, debt management, revenue collection, and payments to suppliers.

Positive working capital generally indicates a company can pay off its short-term liabilities in the short term. Negative working capital generally indicates a company is unable to do so. Too much working capital means business has surplus funds that are not generating a return.

Having a liquidity ratio (current/quick ratio) of less than one is one of the fourteen indicators of insolvency (ASIC v Plymin) and one of the first areas examined by a liquidator when assessing when a company became insolvent.

The amount of finance/funds a business needs to carry out its day to day trading activity is referred to as the working capital requirement, and varies depending on the amount of time the business takes to pay suppliers, the amount of inventory/work in progress held, and the time it takes to collect cash from customers.

Why manage working capital?

Working capital is a daily necessity for businesses, as they require a regular amount of cash to make routine payments and purchase basic materials/services and pay wages used in the generation of its products/services.

The requirement will vary depending on the type of business i.e. a manufacturer will buy and hold inventory of raw materials and incur production costs to manufacture the finished product before selling, whereas an accounting firm will incur the cost (employee wages etc) to prepare returns or provide advice before invoicing a customer. The fundamentals are the same.

A review of the ASIC Insolvency Statistics for the period 1 July 2017 to 30 June 2018 reveals working capital issues was a cause of failure in circa 33% of liquidations.

As outlined by the statistics, when not managed carefully, working capital shortages (i.e. insufficient resources to pay debts incurred) cause many businesses to fail even though they may actually turn an accounting “profit”.

Managing working capital essentially entails managing the cash flow of a business on a daily, weekly and monthly basis in such a way that satisfies all debts while reserving enough capital to continue operations and the generation of profits.

1. How to improve working capital

There are a few simple actions, which can improve a business’ working capital:

1. Improve Accounts Receivables Collections

• Use technology for shortening cycle

  • Deliver invoices electronically, make easy to pay, automate reminders (eg. Xero online invoicing software)

• Invoice correctly

  • Always ensure the invoice issued is correct in all details and with any applicable supporting material (delivery docket, summary of time etc) and it is issued promptly

• Resolve disputes quickly

  • Identify root cause of dispute (and whether genuine) and address

  • Make commercial decision on taking legal action early

• Credit control

  • Always assess a customer before granting credit

  • Consider trade insurance if invoices are large enough

  • Stick to credit limits set (and do not allow sales staff to exceed)

  • Consider shorter credit terms

• Be proactive

  • The longer an account goes unpaid, the harder it can be to recover

  • Call rather than email initially

2. Improve Accounts Payable

• Shorten or improve payment process

  • Use of technology to lessen use of paper and to simplify the payable process.

  • Encourage email delivery of invoices and supporting material

  • Simplify the process with reducing the number of payment runs, recording due dates and early discount dates and communicating with staff about any cash limits

  • Empower AP staff with decisions that lessen owner/director workload but not have negative consequences (decision to make partial payments on large balances, or delay payments to vendors who have a higher tolerance on due dates)

  • On time and early payment discount agreements can easily be lost if businesses are not able to make payments when they are required to, so issues related to process can be costly

3. Improve supplier relationships

• Have up to date contact lists and communicate any expected delays in payment early

• Offer payment arrangements before they start to chase up liability (ignoring calls quickly frustrates a supplier)

• Regular communication with key suppliers

• Seek to improve payment terms

• Try and negotiate better payment terms with materials suppliers and distributors or replacing them with new suppliers

• Vendors will often give discounts, rebates or special terms to customers that purchase large volumes and on a regular basis

4. Manage Inventory/Work In Progress

• Minimise stock levels

  • Do not overstock your inventory. Sell finished goods as soon as possible and hold limited stock in the warehouse. Cut products and services that are not performing

  • Look at keeping minimal stock on hand and ordering from suppliers that can quickly deliver when required

  • Set process to review slow moving/obsolete stock items

• Invoice work in progress consistently

  • Unbilled work in progress has little value unless it is collectable within a short time frame

5. Review tax and other opportunities

• Tax incentives

  • Review all current tax obligations to ensure calculated correctly and rebate amounts applied (i.e. fuel tax credits)

  • Consider whether business can make use of current incentives (e.g. ATO R&D incentive)

6. Other incentives

• Queensland, Australian and local government agencies offer financial concessions to eligible businesses, which can include grants, rebates, subsidies and other incentive schemes

WCT Advisory Group can assist your clients navigate the challenges arising when working capital performance is identified as a key concern. We are experienced in managing and improving working capital and have access to several tools and products, which can assist.

Andrew Weatherley, Managing Partner