How to manage Net Working Capital

Any manager, financial or not, will have heard the term ‘Net Working Capital’ and its impact on cash flow. More and more, this metric is narrowed down to ‘Working Capital Requirement’, the operational brother of NWC. Many people often confuse the two. It is essential for a non-finance guy to have a basic notion of Working Capital, when in business but also when planning on it.

Have a look at how I look at this and if this is relevant for you:

What?

In short, net working capital is ‘current assets – current liabilities’. Take a balance sheet, subtract the two and see if you have a positive number. You do? Good – it means that, if needed, all short term (‘current’) liabilities can be covered by liquidating all current assets.
BUT these assets need to be financed out of other sources than just the current liabilities!

Closely related to NWC is the Working Capital Requirement. To be precise, it is ‘Accounts Receivable + Inventory – Accounts Payable’. So in essence, it lifts all the operational items from the NWC definition and tests just that. If the sum is positive (and it generally will), it means the business has a need for capital to fund the AR and Inventory – the Working Capital Requirement. This is cash ‘trapped’ in the operational cycle of purchasing-holding inventory-selling-collecting. We pay our supplier, but see the money of our own invoices only months later – that is the WCR that we need to manage.

Why?

As menial as it may seem, all the fiddling with payment terms of customers and suppliers, and the mismatch of it, results in a long-term capital requirement. In fact, since these items are so closely related to the day-to-day business, a problem in financing this capital requirement might well send a company in acute liquidity problems and into bankruptcy.

Estimating and following up on this requirement is essentially a task for the finance manager. With sloppy management, or less focus, the WCR can grow quickly and could result in the entire company needing additional funding!

How?

Let’s unravel this WCR and see what we can do to minimize it.

Accounts Receivable. Depending on the business, this often is the biggest part of WCR. This is the sum of all accumulated invoices sent to customers. So minimising this means getting paid quicker:

  • Assign follow-up of invoicing to a member of your customer service. Don’t make it a finance problem, it is an operational responsibility!
  • Link prompt payment of invoices to the bonus scheme of the sales rep – a sale isn’t over until we have the money!
  • Clear, centralised and yet details DSO reporting: the ‘days of sales outstanding’ per customer should be communicated at least once a month. Why not make a race out of it, with the ‘Top5’ best and worst performers.
  • Think twice to outsource this part of financial reporting to a third party. There are many tasks in finance that can be done by any accountant, but AR management, given the customer interaction part, is pretty close to the business!
  • If large enough, hire a collection officer or credit manager
  • Organise ‘credit committees’ with finance and commercial teams involved. Have them look at which customers show erratic payment behaviour.
  • Set credit limit: a customer can buy up to a certain monetary amount, but then it stops; have him pay before you send out any more goods.
  • Set payment terms per customer. And load them into your invoicing system so that deliveries are blocked, or overruns are flagged, automatically.
  • Factoring: you sell your receivables to a bank at a discount. Usually this is a ‘basket’ of invoices (banks rarely will accept you only sell them the bad payers and try to collect the good payers yourself). Watch out you define who takes the risk if the end customer does not pay up! Also, customers might not like it to have a third party collecting their dues, as it happens a lot more forcefully.
  • Instead of giving the discount to a bank, why not give it to the customer? Stipulate a 3-5% discount for early payment (typically within 10 days). Some cash-rich customers will take the bait!
  • Documentary credit; this is more for export-related businesses. Basically, you set up a system with your bank and your customer’s bank that you get paid as soon as good receipt is acknowledged by the customer. It is then the customer’s bank problem to get the customer’s payment as per contracted payment term. Costly, of course.  

Inventory.

  • Supply chain management is essential – just in time is a good practice here.
  • Ask your suppliers to play a role in it. Could VMI reduce the burden on your working capital?
  • Forecasting needs to be as accurate as possible – set up a process to have it monthly updated and follow up on products/units with a large error margin
  • Do however realise that stock-outs are usually much costlier that excess stock

Accounts Payable.

  • In many ways, do the inverse of what you do with your customers. Obviously, try to pay as late as possible. With a bit of luck, your supplier has bad AR management
  • Incentivize your purchasing manager to extend payment terms
  • Or ask for discounts for when paying early

Final words

  • Optimizing working capital does not necessarily hurt margins.
  • Reducing WCR is the cheapest form of funding you can have.
  • Often WCR eats 20% of your company’s funding
  • Don’t take your sector’s benchmark for a given – think Ryanair!

Like this post? Please share it – and leave your comments!

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About curiousmanager

In life there are generalists and specialists. Although your job pushes you down towards a certain specialization, I feel it's important to keep your eyes and mind open for new stimuli. And I want to share my journey through arts, literature and sciences with other knowledge workers and managers. You don't have time to read. Let me do that for you and present only the best of the best in my blog!
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5 Responses to How to manage Net Working Capital

  1. It’s quite clear but unfortunately many companies are not conscius of how relevant is this issue…

  2. Pingback: Task list of a controller – part 1 | The Curious Manager

  3. amit says:

    hello,

    i like your comment ! natural capital accounting provides an effective means for corporations

  4. Natalie Tollenaar says:

    Are you sure you are a curious manager? How about agressive socialist?

  5. Paul says:

    Just to put things into perspective (with all respect to the importance of managing working capital):
    If you give a 3% discount for paying within 10 days, instead of say 30 days, you are getting the most expensive financing in the world: 3% for 20 days is equal to about 55% p.a. interest. And a 5% discount means 91% per annum.
    So if you really, really, really need the cash, why not, but unless the discount also gives you a commercial edge (helps your customer make a buying decision) you are better off with an SMS loan. Or you need to have a serious chat with your shareholders about priorities.
    And to turn it around, where else do you get a 55% interest on your deposit (as long as you don’t allow the discount to influence your own buying decision!)?

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