6 Mistakes When Managing Working Capital

By Benjamin Duffy | July 8, 2021

Working capital is a tough beast to wrangle but achieving your company’s business objectives and maintaining financial health likely rely on it increasing. Optimizing it to achieve increased liquidity and an improved Cash Conversion Cycle (CCC) is difficult because there are so many different areas to focus on.

We see plenty of mistakes made when trying to improve working capital (also known as Net Working Capital or NWC), these are the top 6 that leave the biggest impression:

Mistake 1: Thinking Supply Chain Financing is the only way to materially increase working capital

Supply Chain Financing is essentially the short-term financing available to Accounts Receivable/Payable. It’s where a supplier gets a customer invoice paid by a financer / lender in a short period of time (say, within 10 days) while the customer can wait to pay the financer (generally 60 to 90 days), is often used as the main tool for increasing working capital on either the Days Payable Outstanding (DPO) or Days Sales Outstanding (DSO) side. The financer takes a small percentage at repayment, but often both the supplier and customer have the advantage as they each get their preferred payment terms.

I want to be perfectly frank: Supply Chain Financing is a quick and easy way to increase a company’s working capital. It can make your suppliers or clients happy as well as provide additional cashflow to the business. The problem is many see it as the only real tool to improving working capital when there are many others which don’t involve having to give a percentage of your invoice spend to a financer.

Other ways to improve working capital can include increasing payment terms with suppliers, shortening payment terms with clients, or working to decrease the amount of inventory on hand. Obviously, there are challenges to many of these methods (and mistakes you can avoid make up the rest of this article), but with the right expertise, there are ways to improve working capital without impacting valuable supplier relationships and without having to go solely with Supply Chain Financing.

Mistake 2: Not having the right teams working together to improve working capital

Optimizing working capital can only be achieved when multiple teams work together with that common goal. For example, if Procurement doesn’t care about what the payment terms are beyond ensuring they are long enough for AP to approve and pay the invoice, there is zero reason they would try to negotiate better terms.

Teams across the organization need to collaborate and be held accountable for their role:

• Inventory team works through inventory management to reduce unnecessary excess inventory on hand
• Finance defines the preferred payment terms for clients and suppliers
• Procurement enforces those terms when negotiating with suppliers
• Accounts Payable ensures they are paying per the payment terms
• Sales needs to maintain payment terms in client negotiations when possible
• Accounts Receivable needs to collect based on those payment terms
• Treasury needs to ensure working capital levels are meeting targets and determine ongoing strategy to maintain them

The challenge here is that each of these teams has a different set of responsibilities and goals, and ultimately may report into different functional leads at the C-level.

The CFO (Chief Financial Officer) is likely the person with a clear view of the balance sheet and thus most focused on working capital and generally has control over the Finance, AP, and AR teams. This is a good start, but they still need to generate buy-in across the executives below to ensure the right incentives (or consequences) are in place to make increased working capital a goal across the organization.

The CPO (Chief Procurement Officer) is likely looking at savings and reliability/lead time as their two main metrics. Working Capital increases need to be included as part of savings for the CPO to get on board, with a metric to show how Procurement is impacting it through negotiating payment terms.

Even the COO (Chief Operations Officer) may not have working capital as a top priority, focusing more on the employees, daily operations, and day-to-day operational results. Achieving growth business objectives needs to be made a top priority for the COO, and then that can tie back to working capital.

The solution is finding common ground that will draw these functions together to collaborate towards a defined set of objectives that will meet a collective business objective without causing undue conflict.

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Mistake 3: Letting suppliers and customers dictate payment terms

Almost all organizations have onboarding forms for new business, whether that refers to new suppliers and new customers. The formats and entry methods may vary but they all contain the required data inputs needed to facilitate the payment process. A common mistake we’ve seen is asking for preferred payment terms and simply accepting them without question. There are a few issues with this, one, this may not take into consideration that procurement has negotiated payment terms already or allow them to do so. Two, the team onboarding this new company might be inadvertently setting the precedent that any payment term is acceptable, creating a lot of extra work to manage them all. Finally, this method may save time up front but the impact to working capital can be detrimental.

From the supplier’s side, they are going to enter the most advantageous payment term from their perspective. And you cannot blame them, right?

Instead, a process needs to be developed around payment terms. Advise the supplier or customer on what your standard payment terms are and negotiate based on what will meet your business needs first, taking into consideration what flexibility you may have from a policy perspective. In some instances, they may not accept your standard terms; depending on the nature of the agreement and its criticality to your business you may decide at that point whether you can move ahead with the relationship or if that is a deal breaker. Either way, you can rest assured that due diligence has been done to ensure your business needs are being considered.

Mistake 4: Paying an invoice well before it’s due

This is a simple mistake that is often overlooked. Invoices should be paid as close to their due date as possible while still avoiding late payments. While many organizations abide by this, if it is not the policy of your Accounts Payable department, that group often finds themselves paying invoices as soon as they are approved to ensure they don’t miss payments. This not only lowers working capital with little benefit, it makes it tough when forecasting how much working capital will be available in a specific term, as invoices aren’t paid based on due date.

This may speak to a deeper need for Accounts Payable Transformation, but a key area is ensuring that payments are being made on-time (to maintain supplier relationships) while still happening as close to the due date as possible.

Early pay discounts are one exception to this, where the supplier offers a discount of generally 1-3 percent for paying early. If the discount is strong enough, you should be capturing it and paying the invoice early, although still as close to that earlier due date as possible. One extra piece of advice around early pay discounts: Make sure the savings is documented and reported as a component of savings generated from AP. That will help demonstrate the value that is delivered by the team in hard metrics.

This concept can bring about an additional mistake though…

Mistake 5: Not factoring in the working capital impact with day-to-day decisions

When it comes to early pay discounts, any Accounts Payable team that takes advantage of them needs to have a way to determine when the discount is worth paying early compared to having the additional cash-on-hand. For many companies, a payment term of 1% 10, Net 90 (get a 1% discount paying 80 days sooner) would not be worth the hit to working capital, whereas a 2% 10, Net 45 may very well be. It should not be a guess by an AP associate: just as Treasury will set payment terms, they need to define a method to easily calculate when the discount should be captured.

For almost all other operating areas of the company that involve both money and time, working capital likely needs to be considered in day-to-day operations. For example, when looking at lead time for inventory purchases: Every extra day Supplier A needs over Supplier B should have a cost associated with it from both a warehousing perspective and how it impacts cash-on-hand. The organization will need that many additional days of inventory on hand to avoid a shortfall, and Supplier A’s price should include enough cost buffer to compensate for this.

Mistake 6: Letting suppliers manage themselves

Procurement has put in the effort to negotiate advantageous payment terms in your supplier contracts. However, are the teams working together to ensure compliance with them in order to reap the working capital benefits? The due date on the invoice may not reflect the correct terms, especially if you negotiated something different from their standard. You should never rely on the supplier to properly police themselves. This and other areas of contract compliance need to be enforced or you risk errors in the supplier’s favor harming your working capital.

While this is often just a small part of contract compliance, ensuring payment terms are correct can have a significant impact on working capital. It’s vital that Accounts Payable calculates the due date and validates the information against the contract, rather than assuming what is on the invoice is correct.

If possible, your supplier agreements should have the invoice receipt date as when payment terms start. This ensures that your payment cycle starts when you receive the invoice, not when they create it. This can be a major reason to automate your invoice ingestion process: It can automatically add the date the invoice was received and calculate the correct due date based off of the payment terms set up in the system as well as whether the due date should be calculated from the invoice date or invoice receipt date.

Takeaway

Working capital management is not an easy area to tackle, but it is critical that organizations do so if they want to fully achieve their business outcomes. Many organizations don’t have the necessary expertise in optimizing working capital, so they need to ensure they are not making missteps that could leave significant cash off the table.

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