Release working capital to build company value

In a busy middle market business, working capital is often overlooked and undervalued for its potential to grow a business’s value.

Generating earnings and the cash that flows from them naturally takes center stage. This cash flow funds growth, pays down debt, and adds to the business’s value.  But as a business is growing, a portion of that cash flow goes to working capital to support day-to-day operations. Cash that funds working capital is bound to the business and is no longer available to pay for business growth initiatives or to sink to the bottom line.

Tighter management of working capital can free up cash, giving the business an immediate lift in value. Releasing working capital further improves capital productivity, generating earnings with less capital at work. A higher return on capital is a quality that investors, potential acquirers, and owners all appreciate.

Why should I work on untying my working capital?

Zeroing in on working capital management offers an intriguing opportunity. There’s little financial risk in looking for working capital management improvements to free up additional cash. Working capital efficiency can be additive to other strategic business initiatives without detracting from them. For many businesses, it’s “low-hanging fruit”.

It's easy to overlook working capital. Smaller businesses absorbed with growth don't have time to focus on capital improvement. Bigger businesses miss the opportunity because they're focused on debt and capital structure. This is why middle market companies typically excel at unlocking working capital.

What’s my opportunity?

The best way to see the potential for working capital improvement is to quickly restate your company's financials. How would they have improved with better working capital management? See how your cash flow would change, raise business value, and release capital back to the owner.

Benchmark key metrics like days sales outstanding (DSO) for accounts receivable, days payable outstanding (DPO), and days inventory outstanding (DIO) against peer companies in the same industry.

Look to advisors who know your business, trade groups, government sources, and business studies. Want to see how companies in various industries manage working capital? Check out The National Center for the Middle Market's Working Capital Benchmarking Tool. You can compare benchmarks there with your company.

The distance between the best performers and those who’re struggling can be as much as a four times difference. So set your sights on what you can achieve. Work it through the financials. And see the potential to boost business valuation. This will help you focus on working capital reduction.

The mechanics of shrinking working capital

The principles of squeezing working capital to release funds for more productive use are simple. Working capital is the sum of your cash, accounts receivable, and inventory less your current liabilities, mostly in accounts payable. To lower working capital needs and free up cash:

• Reduce the amount of credit you offer your customers in the form of accounts receivables
• Lower the funds tied up in inventory at every stage of production
• Use the full terms offered by your vendors to increase your accounts payable

As you map out a plan, there are a few tips to consider.

• Accounts payable – Companies often overlook the opportunities in accounts payable. Make sure you’re using all the full range of payment methods with your vendors. Are you using Automated Clear House (ACH) payments, which can offer low-cost electronic payments? What about purchasing cards, which allow you to pay vendors electronically and quickly, while you get extended terms to pay your card?

  Create your payment policy by setting terms by payment method. You might pay vendors within 10 days of invoice with a purchasing card, within 45 days via ACH payment, or 60 days with a check. Your improvement in managing payables will come from financial processes that include the discipline to adhere to these policies.

• Accounts receivables – The best way to reduce receivables is to secure payment at time of delivery or service. Use merchant services or ACH transactions to get paid before you even set up a receivable for your customer. At a minimum, start the collections cycle with fast invoicing for speedier payment.

  Set collections policies and adhere to them using every automated follow up and personalized tool at your disposal. Turning paper to electronic lowers costs for you and your customer while speeding collection. As a bonus, eliminating paper checks means removing a major source of fraud.

• Inventory – Lean management or just-in-time inventory keeps your inventory levels low and matched to your sales volume. Enterprise resource planning (ERP) systems and inventory management systems help keep inventory levels in check, reduce carrying costs, and pinpoint obsolete items.

Create a cash culture.

Companies manage their working capital best when employees across the organization embrace the cash-to-value link.

Imagine a salesperson who’s negotiating payment terms thinking about the best way to get cash in the door faster. Then, it’s not just the finance department worrying about sticking to receivables policy but also employees who understand the importance of cash to build company value.

If you want a staff that thinks like an owner, education on the value of speedy collections or extending payables is a great place to start. And it’s an excellent step toward sustaining value-creating gains in working capital management.