Working Capital Optimization During a Crisis

Businesses are operating in a time of great economic uncertainty. As inflation rises, geopolitical instability persists and bank failures make headlines, you may be wondering: How can my small to mid-sized business stay resilient during a crisis?

In an economic downturn, the key to success is prioritizing liquidity, risk management and access to funding sources. Central to these strategies is optimizing your working capital, which generates the cash needed to operate, invest in inventory and growth, and build a safety buffer.

Working capital optimization is crucial during an economic crisis because financing from traditional lenders may become inaccessible. Banks typically restrict lending to protect their assets, which could jeopardize your funding eligibility and interfere with your buyers’ supply chain financing programs.

What is working capital optimization and how can you use it to maintain a healthy working capital position?

What is working capital optimization?

Working capital optimization is the process of managing current assets and liabilities to generate sufficient cash flow. Current assets include a business’s available cash, accounts receivable and inventory, while current liabilities include accounts payable and short-term debt obligations, usually over a 12-month period. Put simply, optimization strategies aim to turn working capital trapped in accounts receivable, accounts payable and inventory into cash more efficiently. This ensures that the business has enough cash flow to cover operating expenses and short-term debts.

There are several reasons why working capital optimization is crucial to success, especially during an economic crisis:

• Cash is the lifeblood of any business, enabling it to fund daily operations, make growth investments and provide an emergency buffer. Even if a business is highly profitable, it can easily fail without effective working capital management. 
• Working capital optimization is the most cost-effective way for a business to access capital. With the right strategies, a business can unlock cash from its working capital and avoid or reduce borrowing costs.
• Inflation causes dollar values to decrease faster. The sooner a business can turn inventory and outstanding invoices into cash, the more value it has when reinvesting in inventory and other resources.
• Traditional financing is harder to access during an economic downturn due to higher interest rates and stricter requirements. This is especially true for small to mid-sized businesses. Optimizing your business’s working capital may be one of your only cash sources if you can’t secure financing.
• Working capital optimization improves shareholder value and can help attract investors.

How to calculate the working capital optimization cycle

Working capital optimization focuses on three business areas: accounts receivable, accounts payable and inventory. These components make up the working capital cycle, generating cash from accounts receivable and using that cash to pay for inventory and make sales, generating cash again.

The working capital optimization cycle, often called the cash conversion cycle (CCC), measures how long it takes your business to convert inventory investments into cash. CCC is calculated using the following formula:

CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

Here’s how to calculate each of these three metrics:

• DIO is the number of days it takes to sell inventory.

DIO = ($ Inventory / $ Cost of Goods Sold) x 365 Days

• DSO is the number of days it takes to collect receivables.

DSO = ($ Accounts Receivable / $ Total Credit Sales) x 365 Days

• DPO is the number of days it takes to pay bills without incurring penalties.

DPO = ($ Accounts Payable / $ Cost of Goods Sold) x 365 Days

The above formulas calculate the cycle over one year. However, you can change the number of days if you’re working with a different timeline — such as a monthly or quarterly period.

The ideal CCC number varies depending on your industry, but the goal is generally to minimize the cycle length as much as possible. A low CCC indicates that your accounts receivable and inventory are converting to cash efficiently, creating a healthy cash flow.

How to improve your working capital position

If your business is facing an economic crisis, there are several strategies you can use to optimize working capital.

1. Know your cash position

The first step in weathering economic uncertainty is to closely monitor your financials. Forecasting cash flow over the coming weeks, months and quarters enables your business to predict cash shortages and mitigate potential risks. It will also help you build a cash reserve, maintain shareholder value and maximize growth investments if you anticipate a cash surplus. Monitoring your cash conversion cycle is a good place to start. Other key financial metrics include:

• Operating cash flow: Indicates if you’re earning enough to pay the bills.
• Cash ratio: Measures liquidity.
• Free cash flow: Measures the surplus cash available for growth investments.
• Balance sheet: Measures assets, liabilities and shareholder equity.
• Gross profit: Measures earnings minus the cost of goods sold.

2. Shorten your CCC

After investigating typical CCC values in your industry and performing a cash flow analysis, you may discover that your cycle is too long. By breaking down DIO, DSO and DPO, you can illuminate the source of a long cash conversion cycle: Is inventory building up because of slowing customer demand? Are your buyers taking too long to pay invoices? Or are you paying bills earlier than you need to?

While improved inventory management or marketing strategies can lower days inventory outstanding, an economic crisis can make it challenging to control this metric. You can, however, increase DPO by delaying your bill payments as long as possible before maturity. You can also shorten days sales outstanding by negotiating shorter payment terms with buyers, using early payment incentives or implementing invoicing best practices.

3. Improve invoice management

There may be opportunities to improve cash flow by changing your business’s invoicing practices. The sooner your buyers receive invoices — and the easier it is for them to make payments — the faster you are likely to convert accounts receivable into cash. You can use your invoices to optimize cash flow by:

• Automating invoices. Rather than submitting invoices manually, use invoicing software to create and send invoices. This software makes it easier to keep track of outstanding invoices and can automatically follow up with buyers that are approaching or past the invoice due date.
• Using invoice templates. Templates reduce errors by ensuring consistent and accurate data entry. Visually appealing templates, as well as those that include polite language, can also encourage buyers to pay faster.
• Timing invoices strategically. The best time to send invoices is usually as soon as possible. However, your buyers may be more likely to open emails and make payments at peak times, such as midday and midweek. 
• Offering multiple payment types. Buyers are more likely to pay promptly if it’s convenient for them to do so. Avoid manual payment solutions such as checks, and stick with online, automated and card payment options.

4. Investigate lender relationships

5. Explore alternative working capital solutions

When working capital optimization strategies aren’t enough, you may need financing. However, traditional financing options such as working capital loans may be inaccessible to small to mid-sized suppliers — especially when interest rates increase and requirements get stricter. Thankfully, there are alternatives that your business can leverage.

For example, peer-to-peer (P2P) lending funds businesses without using traditional institutions. P2P platforms connect businesses with a network of lenders, often with better interest rates and more flexible requirements than banks. Asset-based lending is also more accessible to smaller businesses and those with limited credit histories. This lending type secures working capital financing against an asset to reduce risk, and often comes with better rates and terms.

You can also leverage early payment programs — which allow you to get paid faster in exchange for a small discount — to optimize working capital without taking on debt. Programs such as C2FO’s are already implemented by a large network of enterprise buyers. Suppliers simply use the online platform to view outstanding invoices, choose which ones to accelerate, set a discount rate and receive payment once the request is approved. Unlike traditional supply chain financing, these programs don’t rely on a third-party institution to function, making them sustainable during a crisis.

The takeaway

Traditional lenders may be the first place a small to mid-sized business goes to seek funds when an economic crisis looms. While borrowing can help your business weather fluctuating market conditions, optimizing your working capital can be a more cost-effective and accessible way to access cash. Working capital optimization enables you to convert accounts receivable and inventory assets into cash more efficiently.

The good news is that many working capital optimization strategies — such as measuring your cash position, improving your invoicing strategy and leveraging early payment programs — are solutions you can implement right now.

Learn more about early payment programs as a debt-free way to optimize your working capital.