The Importance of Working Capital Management

  Small and medium-sized enterprises (SMEs) must make the maximum effort to optimize their cash to face the competition and collaborate with larger businesses. An SME may survive for some time without profit, but a lack of it can compromise its prospects. There are many practical ways an SME can optimize its working capital without infusing external finance.   An SME’s financial managers should manage cash just as in recessionary conditions, as tightly as possible, while operations and sales focus on the operational efficiencies and service levels, respectively. This balancing act will optimize working capital levels and enable the flexibility to support top-line growth in opportunistic business conditions.  

THE DISCIPLINE OF METRICS

  As Peter Drucker famously said, “what gets measured gets managed,” and this holds too for fine-tuning and improvements to reach our desired goals.   Forecast, update, and review the 13-week cash forecast biweekly. The discipline of making a biweekly, 13-week rolling cash forecast helps with planning and control of cash timing in and out. For the ensuing two weeks, this forecast needs to be reported weekly to explain any variance in how actuals match to forecasted amounts. This routine will help fine-tune the 13-week forecast to improve its accuracy and cash planning and shed light on short-term corrections.   Report the cash conversion cycle (CCC) as the main financial metric. To unlock the idle cash-out, the objective should be to turn the money over faster (more turns) by shortening the CCC period. CCC measures how fast a company can convert its initial cash into cash from invoiced revenues. Money returned to the company will be used many times to churn in more profits through the repeat revenue cycles. To grow only the top line with poor collections will eventually hurt cash flow and profitability. Therefore, include CCC trends as part of the financial reporting package.   Coordinate a metrics tracker system. Finance should take the lead role in coordinating the system’s setup, tracking, and reporting. Targets for the metrics should be set based on planned continuous improvements from systems driven by cross-functional participation. They should be tied to performance evaluations through individual, functional, and company-wide compensation programs.  

OPTIMIZING THE PRICING PROCESS

  SMEs require a good, competitive pricing strategy today to participate profitably in complex and volatile commercial environments.   Create and maintain robust costing and pricing processes. Good cost accounting and related pricing systems are essential to successful revenue generation. Standard costing produces incorrect decisions in many aspects of profitability analysis, which in turn produces weak pricing. Accountants should keep separate cost/profitability models for different vital processes utilized by their products. They should then focus on pricing those products using the current process rates to determine the price. Accurate bills of materials, routing, scheduling systems, and other production data improve product costing and pricing.   Accountants should also be aware of the strategic purpose of pricing for different situations. These include target pricing, total cost-plus margin, incremental/marginal pricing, or volume rebates. Volume rebates are a great tool to use after the year-end instead of lowering prices. This helps the cash flow and serves as a buffer for cash collection or a cushion for bad-debt challenges.   With a closer watch on the competition, increase prices creatively in today’s inflationary environment. Naturally, this comes with a trade-off price increase that may result in the departure of an existing customer. It’s always costlier to acquire a new customer than maintain one at a slightly lower margin. Finance needs to evaluate this trade-off under scenario modeling.   Nurture customer/supplier relationships. These factors significantly influence cash management via working capital turnover efficiencies—working hand in hand with customers and suppliers, especially in today’s uncertainties. The faster you identify the changing needs and respond to your competition, the more you secure a substantial competitive advantage with better resiliency. Customer/supplier relationships and operational excellence are critical prerequisites for optimal working capital.   To support good relationships, visiting key customers and suppliers, setting up good terms and agreements, and communicating and enforcing credit policies will help. For accounts receivable and accounts payable, to speed up the cash cycle, automate or minimize invoicing and processing cycle times, increase efficiencies in lockbox collections, and effectively manage invoice discounting or factoring policies. To optimize inventory, implement systematic reviews for stock-keeping unit (SKU) rationalization and optimization for colors, sizes, and package types with market support.   Use outsourced additive manufacturing and take advantage of 3D printing at low costs for composite parts to avoid carrying a larger volume of subassembly parts. Outsource specialized SKUs in lower quantities to reduce design and assembly time. Pre-buy if the adequate operating ability is in place with the same extended terms. Outsource small volume simple SKUs with larger varieties and drop-ship them to customers.   Monitor the environment and watch for red flags. It’s vital to be aware of the economic and political impacts of inflation, fiscal and monetary policies, and global effects, especially in China and Europe, including supply-chain impacts and new subsidies. Prompt response to significant current events and future expectations has implications within the competitive landscape: new entrants, substitutes, technology changes, etc.   Recognizing early signals will help mitigate the working capital build during reporting time due to the lag time. They’re primarily visible via bottlenecks; work-in-progress buildups; rework; excessive scrap and moves; wait times; redundancies from man, machine, and materials; increased safety incidents; and customer complaints.   Red flags are the early warning signals as the leading indicators, unlike most lagging traditional metrics. Therefore, prompt attention to them is key to any successful operation. On the other hand, ACSM’s working capital study Managing Operational Performance in Volatile Times reveals three best practices among top-performing companies:  

• Customer relations: putting the customer first
• Inventory and working capital: moving from “reduce” to “optimize”
• Costs: controlling costs while upgrading capabilities

  All three recommendations are crucial to balancing an SME’s long-term success and the care needed to optimize rather than reduce the working capital. Working capital management targets should align with the SME’s strategic goals. Most importantly, to be resilient in today’s volatile environment, the culture should focus on systems to attain goals and continuously improve.