Working capital management aims at securing and optimizing the liquidity of an enterprise. It helps companies effectively make use of current assets and maintain sufficient cash flow to meet short-term goals and obligations.
Working capital is essential to the health of every business, but managing it effectively is something of a balancing act. Companies need to have enough cash available to cover both planned and unexpected costs, while also making the best use of the funds available. This is achieved by the effective management of accounts payable, accounts receivable, inventory, and cash.
Working capital management is the process of improving the cash conversion cycle for companies across payables, receivables and inventory. The cash conversion cycle, typically represented in days, is the time it takes a business to convert expenses into cash flow. The cash conversion cycle (CCC) is defined as: CCC = DSO + DIO – DPO.
- DSO is “Days Sales Outstanding” (Note: a “receivable” is outstanding sales)
- DIO is “Days Inventory Outstanding”
- DPO is “Days Payables Outstanding”
The liquidity of an enterprise can be tied up in each of these areas. Their cash is “trapped” and cannot be used for other purposes as long as it moves through the supply chain. This needs to be avoided. Decreasing DSO, decreasing DIO and increasing DPO lowers a company’s CCC. In other words, it accelerates their cash flow.
There are solutions for each area of the cash conversion cycle which help to improve the liquidity situation of the company.
These are “buyer-led,” i.e. the buyer enables the supplier to receive cash earlier. In those cases, the cost of early payment is based on the buyer’s credit rating. Since buyers are usually large companies with access to attractive financing conditions, early payment can be much less expensive for suppliers than other financing options which are based on the supplier’s own creditworthiness. Payables solutions take two primary forms:
- Supply Chain Finance: The supplier is paid early using funding from a third party. The buyer then pays the funder upon the original maturity of the invoice.
- Dynamic Discounting: Early payment is made directly by the buyer to the supplier allowing the buyer to obtain a discount on the invoice.
These are “seller-led” and allow businesses to receive early payment on their invoices across some or all of their customers.
This is a type of short-term funding that helps optimize financing of inventory.
Compared to other methods of obtaining cash, working capital management is particularly beneficial to businesses, because it is directly linked to receivables and payables of buyers and suppliers. Thus such solutions can strengthen the buyer-supplier relationship and provide financial benefit to both parties.