Optimizing working capital: what CFOs need to know

We often see leaders hyper-focused on sales and P&L statements. Naturally, working capital – the money that keeps your business running smoothly – takes a backseat.  

From meeting operating expenses, payroll, and supplier payments to investing in growth opportunities and protecting you from uncertainties, working capital optimization can have a significant impact on multiple areas of your business. The stronger your working capital gets, the better your liquidity, profitability, creditworthiness, and overall business growth will be.  

Understanding working capital optimization 

Working capital optimization is about achieving a balance between your current assets and current liabilities, with the primary aim of strengthening liquidity and cash flow. It adopts a holistic approach, effectively managing 3 key pillars - accounts receivable, payable, and inventory management.  

While positive working capital indicates enough short-term assets to meet short-term liabilities, negative working capital shows struggles in meeting immediate obligations, which often leads to borrowing on unfavorable terms.  

With working capital management, the ultimate aim is to ensure there is enough cash for running daily operations, paying off debts, and investing in growth, all while staying financially stable.  

Working capital optimization matters. Here's why.

When cash is trapped, it hinders your ability to run simple day-to-day operations. That’s precisely why optimizing working capital is a strategic necessity that helps boost cash flow and operational efficiency.  

Sharing the top 5 reasons you should prioritize working capital optimization: 

Enhances cash flow and liquidity

With effective working capital management, you can amp up your cash flow, ensuring there is enough money to meet operating expenses, fund growth initiatives, and make the most of opportunities available. Strong working capital also means your business can avoid cash crunches and minimize delays in supplier payments. And best of all, it keeps you well-prepared for unexpected financial challenges and market downturns. 

Mitigates financial risks

Ups and downs in the market are inevitable. However, as a business, you should be able to navigate these changes seamlessly to ensure they don’t impact your operations.  

A well-managed working capital safeguards your business against market volatility and supply chain disruptions. This gives your business the power to withstand financial shocks such as rising interest rates, defaulting customers, or random expenses arising out of the blue. 

Drives operational efficiency

One of the most important reasons you should prioritize working capital management is that it ensures a smooth flow of funds for running business operations seamlessly. With adequate funds, you can prevent any slowdowns or disruptions when carrying out operational activities such as paying suppliers, processing payroll, and procuring stocks.  

Additionally, working capital optimization enables you to allocate resources more effectively so that funds are not tied up in idle inventory or delayed receivables.  

Improves creditworthiness

A strong working capital position speaks volumes about your company’s financial health, attracting attention and interest of both lenders and investors. By judiciously managing short-term assets and liabilities, your business demonstrates solid liquidity and lower financial risk. This can improve your credit ratings and also help you build confidence in stakeholders. When stakeholders start trusting your financial strength, it gets easier to secure funds at low rates and negotiate favorable terms with suppliers.   

Working capital metrics that should be on your radar

 A regular and close review of working capital metrics and KPIs is a great start to keep tabs on your liquidity, operational efficiency, and financial stability. Here are some of the key financial metrics every finance leader should track to analyze working capital:  

Current ratio 

Current ratio or the working capital ratio, is an indicator of your company’s ability to pay off its short-term liabilities using its current assets. It shows whether or not you have enough assets to meet immediate obligations, giving a clear idea of your liquidity strength and financial health.  

Typically, a ratio of 1 or above is considered healthy. However, the concept of what’s good and what’s not depends on your company, the industry you are operating in, and your competitors.  

Quick ratio  

Quick ratio, or the liquidity ratio, is a useful metric to gauge your organization’s short-term liquidity position. Including only cash and cash equivalents, such as marketable securities, gives a fair picture of the amount of cash you have currently to meet immediate financial obligations. It’s a stricter measure of your working capital than the current ratio, as it only includes assets that can be quickly converted into cash and omits everything that takes longer to be liquidated.  

A ratio above 1 is considered good and shows that you have sufficient liquid assets to discharge short-term liabilities.   

Days Sales Outstanding (DSO)  

DSO measures how long it takes to collect payments from customers after a sale is completed. This financial metric tells a great deal about how meticulous your accounts receivable process is and how efficient your team is in ensuring timely collections.  

While a higher DSO indicates a long waiting period to receive payments, leading to cash flow challenges, a lower DSO is a sign of prompt payments and steady cash flow.  

Days Payable Outstanding (DPO) 

DPO tracks the average amount of time it takes to pay suppliers and clear your bills. A vital indicator of how efficiently you are managing your cash outflows, DPO is typically calculated quarterly or annually.  

While a higher DPO indicates that you are using your cash resourcefully by delaying payments, however, it must align with supplier terms. Also, if it takes too long to pay suppliers and creditors, you may risk spoiling your relationship with them.  

 A lower DPO, on the other hand, signals that you are paying your bills quickly, which shines positively on your financial health. However, a low DPO also suggests that you are not availing yourself of the flexibility and discounts offered by suppliers. 

Days Inventory Outstanding (DIO) 

DIO is another crucial working capital metric that shows how long you hold onto your inventory before selling it off. It measures how quickly and efficiently your sales team is able to free up the cash tied up in inventory.  

The lower your DIO, the faster your inventory is turned into cash, showing efficiency in terms of inventory management and sales. On the contrary, a high DIO is a sign of excess inventory where your hard-earned cash is stuck.  

DIO varies across industries, so a proper analysis can be achieved only after factoring in the space your company is operating in.  

Winning strategies to optimize your working capital

Optimizing working capital is not just about tracking financial figures. It's about adopting a strategic approach to enhance your cash flow, so that business operations can be carried out with minimal disruptions.  

By implementing the working capital optimization strategies listed below, you can strike a balance between financial stability and business growth.   

Think holistically 

Effective working capital management requires a holistic approach – one where you examine the current situation from all possible angles, taking into account every factor responsible.  

Think of all areas where your cash is mostly tied up and work collaboratively with different teams to align payment cycles and improve cash flow. Assess key metrics mentioned above and find problematic areas that need your immediate focus.  

And lastly, you need a comprehensive approach that integrates working capital decisions with revenue goals, operational efficiency, and long-term financial growth.  

Review and improve your payment and collection terms 

A company’s liquidity largely depends on how swiftly it collects payments and how seamlessly it manages its outgoing cash. By optimizing collection and payment terms, you can free up cash and strengthen your working capital, without straining customer or supplier relationships.  

To speed up accounts receivable collections, simple steps like reassessing credit policies, conducting creditworthiness checks, and enforcing penalties for late payments can work well. Running discounts for early payments is another great way to accelerate collections.  

For accounts payable, see if you can extend the payment deadlines without attracting fines or hurting supplier sentiments. Favorable supplier terms will help you hold onto your cash for a long time and use it for something more purposeful, while still meeting suppliers’ terms and conditions.  

Improve inventory management 

Excess stock can be detrimental for your working capital. It means your stock is taking too long to sell, keeping your hard-earned money trapped.  

By managing inventory effectively, you can:  

• Maintain optimal stock levels, avoiding over-purchasing or understocking 
• Minimize excess inventory and replenish the stock based on demand 
• Free up your cash and build better relationships with suppliertos  

There are several ways you could achieve this. Adopt a just-in-time (JIT) approach that helps you procure stocks only when there is demand. Identify slow-moving inventory by regularly reviewing your stock turnover rates. This is a great way to eliminate obsolete products and optimize your working capital.  

With a meticulous approach to inventory management, you can significantly reduce holding expenses, improve cash availability, and boost operational efficiency.  

Get a grip on your cash conversion cycle  

It’s critical to have a good hold over your cash conversion cycle as this will help you peer through areas where your cash is tied up. These areas could be your inventory, accounts receivable, and accounts payable.  

Since CCC measures the amount of time it takes your business to turn your investments in inventory and other resources into cash, the shorter this cycle, the better. A longer CCC may indicate potential cash flow bottlenecks and a weakening working capital position.  

So, what can you do to improve your cash conversion cycle or working capital cycle?  

• Work on your receivables collection through better invoicing practices and credit management.  
• Strategically time your payments to suppliers without straining relationships 
• Improve inventory turnover to avoid excess stock tying up your cash.  
• Empower commercial, procurement, and supply-chain teams to work together to improve your CCC 

Harness the power of working capital analytics  

Backing every decision with data is a sure-shot way and one of the best strategies to improve working capital.  

Be it accounts receivable, payable, inventory management, or cash flow, when you have the right data up your sleeves, you can make intelligent decisions and manage working capital with greater precision. The best thing about analytics is that you get to prioritize the KPIs that really matter and get insights at your fingertips for informed actions.  

With finance analytics software, you can conduct working capital analysis by uncovering patterns in late payments and identifying high-risk customers, tracking invoice processing time, and keeping a close watch on your supplier payment cycles. You can also peer through the historical data to anticipate potential challenges and address them preemptively.  

Additionally, AI-powered analytics tools can improve forecasting accuracy and provide real-time visibility into the working capital metrics that really matter, so you can be proactive with your efforts. You can also automate the follow-up process for your high-risk customers and get the desired results faster.  

AI-powered analytics takes you from a reactive to a proactive, data-backed approach, ensuring financial resilience and long-term growth.  

Focus on cash flow management 

Optimizing working capital ultimately comes down to effective cash flow management.  

Since cash is the element driving your working capital, it’s important to have full control over where and how your money is going out and coming into your business. This means having a firm grip on your receivables, payables, and inventory management, and aligning your cash inflows and outflows to prevent a liquidity crunch.  

Another way is to keep an emergency cash reserve that can come to your rescue when there are unexpected expenses or market downturns. Besides, you can use analytics tools to predict cash shortages or surpluses and plan your next actions and make proactive decisions. 

With such a well-thought-out approach, you can significantly improve your financial agility and long-term resilience.   

Master working capital for long-lasting success  

A strong working capital translates into better liquidity to run your day-to-day operations and meet short-term financial commitments. It helps ensure that your business not just stays afloat but keeps thriving even when the external situations are not in favor. Improving it means you can free up cash and utilize it in a better way, enhancing the financial health and profitability of your business.  

In fact, skilled management of working capital can help preserve cash and provide a lifeline when your business is facing financial headwinds, economic disruptions, or internal liquidity challenges.  

What’s important to note is that there is no single recipe to boost working capital. You need to adopt a holistic approach, pull the right levers, and implement the best practices listed above to gain significant rewards.