Recent disruptive events, such as the pandemic and geopolitical instability, have exposed the slow reaction of supply chains and a lack of agility in working capital levels. As a result, 65% of business executives responding to a recent survey named working capital efficiency as a critical objective for change management and restructuring activities [1].
Cutting your working capital cycle can unlock cash that can provide a lifeline during tough times, as well as freeing up cash that allows you to take advantage of new opportunities to grow.
Read on to understand how to go about reducing the working capital cycle in your business.
What is the working capital cycle?
The working capital cycle (WCC) is the time it takes your company to turn net working capital (assets – liabilities) into cash. If your business makes cars, your WCC would refer to the time it takes to turn the materials you buy into cars, then sell them and get paid so there is cash in your bank.
It’s usually expressed in days, and can be identified using the following formula:
WCC = inventory days + receivable days – payable days
This formula might vary for different types of businesses. For example, not all companies will hold stock, and therefore don’t need to count inventory days.
Businesses generally aim for a shorter working capital cycle, explains Andy Smith, founder of Abbeygate Financial. “Trying to raise cash today is much harder, so businesses need to know what cash they have, and try to bring it in faster and keep it for longer,” he says.
Benefits of a shorter working capital cycle
A long working capital cycle means that cash is tied up in your business, which could lead to missed opportunities, says Smith. “I worked with a business recently that wanted to lease a new gym building and had raised £15,000 to pay a deposit.
“The client lost the building to a competitor because that business was able to put down a deposit and three months’ rent upfront.”
Freeing up cash by reducing the working capital cycle can help your business survive slow times, but it also means you’re able to and ready to capitalise on opportunities for growth.
For seasonal businesses, a short working capital cycle is even more important, since this makes it easier to survive quiet periods, even if there’s not as much revenue.
Dragon Mobility specialises in making bespoke powered wheelchairs for adults and children. Each wheelchair takes up to 18 months to build, and costs up to £20,000.
“We have to know that we have the working capital to buy all the materials, and to cover payroll during that period, so our working capital cycle is critical,” says Ruth Everard, the company’s managing director.
Over the last 17 years, the company has gradually introduced processes designed to reduce the working capital cycle and increase available cash. This has included streamlining manufacturing processes to speed up inventory turnaround. “We now buy standard components such as motors in advance and in bulk. We will also get standard parts of machinery laser cut in batches because I can pay £100 to have one part laser cut, or £110 to have that part cut 20 times,” Everard says.
This change has only been possible as Dragon Mobility has also taken steps to bring money into the business more quickly, with advance billing, and then using cash reserves to negotiate larger volume orders with lower unit prices, she says.
“It’s all about doing what we can to keep more money in the bank, so we can take advantage of those opportunities.”
How to reduce working capital cycle
Business owners that want to reduce the working capital cycle need to speed up money coming into the company, or slow down money going out. This can be achieved using four key strategies:
1. Negotiate better credit terms with suppliers
One way to keep cash in your account for longer is to negotiate payment terms with suppliers. When you are in a new supplier relationship, you might need to pay upfront or pay upon receipt of goods, but if you have a longer-standing relationship with a supplier, and particularly if you’re buying in volume, Smith recommends asking for better terms. “If you’ve built up trust, it’s worth asking if you can pay on 60-day terms rather than seven,” he says.
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2. Reducing inventory cycles
Smith’s second suggestion is to look at ways to get products or services to market more quickly. This effectively means reducing the time that your capital is tied up in non-cash current assets. “If you look at the auto industry, companies might have a car serviced and cleaned ready to sell, and then spend 14 days taking photographs and writing listings,” he says. “If the business could reduce the time taken to list every car by just four days, and therefore reduce the time taken to be paid for that car, the impact over a month or a year is potentially huge.”
3. Reduce inventory volume
One of the most effective ways to reduce your working capital cycle is to have less cash sitting around in the form of stock. Using better stock control can help reduce the amount of time stock is held, and companies could look at ‘sale or return’ agreements with suppliers to reduce cash being tied up, says Smith.
4. Collect cash from receivables faster
Perhaps the easiest way to reduce the working capital cycle is to speed up the time it takes customers to pay you. This could mean changing payment terms, but Smith advises business owners to be cautious in this regard. “If you’re in a sector where 60-day payment terms are the norm and you demand monthly payments or advance billing, you might make the business less competitive,” he says.
Smith suggests looking at matching the most favourable payment terms in your sector and considering using invoice factoring if necessary.
“It might be worthwhile looking at factoring, where you issue a large invoice, the bank pays you immediately, and then keeps the money when the invoice is paid,” he says. “You’ll pay a percentage commission to the bank, but if you can’t reduce payment terms, factoring does free up a lot of time for you to work on your business, rather than juggling cash.”
However, invoice factoring isn't a viable option for a company like Dragon Mobility. "We are making custom products that take a lot of time and money so we can’t take the risk of someone cancelling an order without paying,” says Everard. “Whether someone is using it or not, we still have a £20,000 machine that’s been built to their specification.
“By asking for payment up-front we have that bit more working capital available, which means we can order materials in bulk and get better pricing.”
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