Understanding the Strategic Importance of Net Working Capital in Business Financial Health

How many months of cash reserves does your business have? Three months, five months, or 12 months? Most small businesses do not have the right answer to this and run out of cash to cover their day-to-day expenses. While you may see profits and incoming cash in the books, it may not be in the company’s bank account, which could lead to cash shortfalls, dependence on high-cost credit, and reduced profitability. Working capital issues can crop up for several reasons, such as expanding too fast, taking on too much debt, having a large pile of unsold inventory, or delays in project completion. 

Why Is Working Capital Important?

For many, working capital is just an accounting formula.

Working Capital Ratio = Current Assets (cash, accounts receivable, inventory) ÷ Current Liabilities (short-term payables, accrued expenses)

If a company has $50,000 in current assets and $25,000 in current liabilities, its working capital ratio is 2.0, indicating that current assets are more than sufficient to cover current liabilities. The ideal ratio depends on the industry and business model. For instance, a grocery store may have a different working capital need than a luxury car showroom.

Having too little cash could stall growth, but having too much could mean you are not investing in growth and innovation. Maintaining the right balance keeps your business moving and growing efficiently.

Even a perfect working capital ratio could be misleading at times. The business may have high current assets, but a majority of that cash could be stuck in receivables. This could force the business to take out short-term credit to pay employees, suppliers, and the government (taxes), as it doesn’t have access to the cash it’s earned.

A robust working capital system answers questions like:

• Can the business pay suppliers and employees on time?
• Can it absorb demand or pricing shocks?
• Can it fund a big order?

A fractional CFO brings financial discipline, controls, and levers to manage working capital by forecasting cash flow, tracking receivables, optimizing inventory, and negotiating payables. They align working capital with the changing needs of the business to ensure growth is not stunted and operations are not shut down for lack of funds.

How CFOs Can Fix Working Capital

If your business is struggling to keep up with the payments, a fractional CFO can help by fixing the key components of working capital: accounts receivable, inventory, payables, and cash flow.

1. Accounts Receivable: A major reason for cash struggles is cash stuck in accounts receivable. A fractional CFO will review aging receivables and prioritize overdue accounts. They will send automated reminders to expedite customer payments or negotiate an extended payment schedule for customers in default.

• A CFO will establish financial discipline by enforcing clear credit policies and strict invoicing protocols. They will also offer early payment discounts to encourage timely payments.
• They will establish a target range for days of sales outstanding (DSO). If the DSO exceeds a certain threshold, the invoice will enter stage 2 of recovery.
• They will keep plan B by arranging pre-approved credit lines with attractive interest rates to bridge the gap between inflows and outflows.

2. Accounts Payable: The next step is to ensure there is a buffer time between cash inflow and outflow.

• The CFO will negotiate 60- or 90-day payment agreements to lengthen the cash conversion cycle.
• They might use supply chain financing, wherein the vendor allows the business to keep inventory on credit and pay the vendor when the inventory is sold. This will free up liquidity for the business.
• If there is sufficient cash, the CFO might seek early-payment discounts from vendors to achieve net savings.

3. Inventory: Inventory is another area that could be eating up cash. The CFO uses multiple strategies to boost inventory turnover, which in turn improves receivables and frees up cash for payments. If the inventory is aging, the CFO may sell it using strategies such as bundling, discounts, or selling in different markets. This will help recover costs and, where there is scope, generate some profits. And most importantly, it will save on the fixed cost of storing unsold inventory.

The CFO will set up a financial discipline to improve inventory efficiency through:

• Just-in-Time Ordering to avoid excess stock and reduce holding costs.
• Focus on high-impact stocks to improve inventory value and turnover rate.
• Calculate and maintain adequate buffers to prevent stockouts in case of a change in demand.

4. Cash Flow: At the start of the article, we asked, how many months of cash reserve does your business have. A CFO determines an adequate cash reserve depending on the current business and economic scenarios. They integrate real-time bank feeds, deploy rolling 13-week cash flow projections, develop plans for different scenarios, and stress-test cash flow to identify potential cash shortages and surpluses, and accordingly determine adequate cash reserves.

How Fractional CFOs Manage Working Capital

A CFO not only optimizes working capital but also manages it efficiently to ensure long-term capital expenditures do not affect real-time operational needs. If your operations are running smoothly but you are struggling to grow them, a CFO can unlock efficiency through working capital management.

Sync Liquidity with Changing Business Needs

Business is never stagnant. It is either expanding, downsizing, or restructuring. A CFO aligns working capital targets with strategic objectives. For instance, tweaking the DSO targets with new product launches, syncing cash conversion with capital raising, and increasing target liquidity to manage cyclical downturns. They align working capital to annual budgets to ensure there is always cash to meet business goals.

Optimize Capital Allocation

A CFO looks to make the best use of capital. They will allocate cash reserves to high-return-on-investment (ROI) projects and keep adequate buffers to give new stores and products time to break even. They will compare the actual cash flow with the forecast and refine their budgeting and forecasting.

Consistently Look for Opportunities to Improve Liquidity

There is always a way to unlock cash if one looks for opportunities. A CFO keeps reviewing cash flow and implements strategies suitable at that time. For a business that has secured a large order, a CFO could unlock liquidity by negotiating early payments and larger volume discounts with suppliers. They may also buy equipment on a sale-and-leaseback basis, freeing up liquidity while procuring brand-new equipment for the business.

A robust working capital management can help the business withstand a crisis and seize growth opportunities.

Contact KSSP Partners LLP in Markham to Help You Manage Working Capital

Talk to a fractional CFO to help you determine your business’s financial needs. At KSSP Partners LLP, our accountants and fractional CFOs can provide services such as budgeting, cash flow forecasting, inventory management, and financial statement analysis. To learn more about how KSSP Partners LLP can provide you with the best accounting and CFO services, contact us online or by telephone at 289-554-5997.