At a glance
- Understanding the working capital cycle – the time it takes to convert net assets and liabilities, such as stock, into cash – is vital for small businesses. It allows you to understand what financial resources you need to operate and grow.
- To improve your company’s working capital cycle, look at ways to accelerate the time it takes you to get paid – by having strong credit control procedures, for example.
- Explore techniques to reduce how much you have in non-cash assets – like only holding as much inventory as you estimate you will need, or selling consignment stock.
One of the most frustrating growth barriers many start-up owners face is a lengthy working capital cycle (WCC). If you face this knotty problem, the sooner you untangle it the better.
An extended cycle means your capital is tied up for longer without a return, which can starve you of cash and hinder your growth plans. Shorter cycles allow you to generate cash faster, be more agile, and hasten progress.
How to calculate working capital cycle
WCC is determined by subtracting current liabilities (what you owe) from assets (what you own and are owed). It is sometimes calculated as inventory days plus receivable days, minus payable days.
For example, a manufacturer buys materials on 30-day credit (payables). On average, it takes 40 days to make its products and sell them (inventory), and customers take 25 days to pay (receivables). This firm’s WCC is therefore 35 days (40+25-30). But adjusting any of those three levers could shorten the cycle to free up more cash and help the company progress.
“It’s critical to understand your WCC, so you can predict your business’s financial resource needs,” says Andrew Shepperd, Co-Founder and Director at consultancy Entrepreneurs Hub.
“With well-managed WCC, your business can grow profitably. Manage it poorly and you will struggle to fund growth, miss opportunities and waste time moving money between one urgent payment situation and another.”
Smart businesses also often work out or estimate what each day of WCC costs them, to then calculate the value of initiatives that reduce it. Here are eight ways to shorten your cycle.
Minimise your inventory
Start-ups that make or sell products sometimes hold unnecessarily high stock levels for fear of running out. But to shorten WCC, you should aim to hold just enough stock so that your products are always available and you have enough to trade, but no more.
Avoid holding slow-moving items, or examine whether you could order them only when a customer buys one; this is known as back-to-back ordering.
Sell consignment stock
Some manufacturers allow you to hold consignment stock, which means they only invoice you when it sells. “Consignment stock is available in many sectors,” says Andrew. “An example might be a Japanese manufacturer expanding overseas but with no local presence – particularly one with niche or high-cost items that sell in small numbers.
“Rather than rush shipping or bear the cost of establishing local logistics, they may look for a distribution or fulfilment partner who will hold the stock for them and, in return, they won’t invoice it until it sells.”
Take payments instantly or via credit card
Where possible, get customers to pay you instantly or via credit card, which enters your bank account immediately. Credit card payments allow the customer to pay later, are highly secure, and often include insurance. The only downside for you is the handling fee, but this could be well worth it to reduce your WCC and credit risk.
“Many retailers, including supermarkets and online sellers, have flourished by generating large cash amounts through credit card payments – often on stock they’ve not yet paid for,” says Andrew. “Selling online is a great way to optimise WCC because it can make the ordering process more efficient and less prone to error.”
Offer a prompt-payment discount
This can be controversial as any good business should pay its suppliers on time. But if they don’t, a prompt or early-payment discount can be a pragmatic way to incentivise good behaviour.
Such a discount can be a win-win if you’re working with a larger, cash-positive customer but your company is in debt or cash-strapped. The discount improves the customer’s margin. For you, it cuts the cost of debt and/or enables you to grow faster. It can also be much cheaper than paying a credit control team to chase payments.
Have robust credit control procedures
Credit control encompasses everything you need to systematically ensure customers pay invoices on time. It may include elements such as a good invoicing system, an accounting system that automatically chases payments and sends alerts, and a dedicated team to chase late payments.
“There’s always a reason for late payment,” says Andrew. “It could be an invoicing error; the customer is not happy with your product or service; they don’t value you as a supplier generally; or they have financial problems and have become a credit risk. Late payment should be seen as a possible indicator of wider business-health issues. Often, investigation can show opportunities to improve your business performance and efficiency.
Create a commercial framework
If you don’t have contracts with key customers, consider implementing them as they reinforce your payment terms. Also consider widening this into a commercial framework that includes agreements on areas such as pricing and service levels.
Andrew says such a framework encourages clients to meet your payment terms because they understand what a good service they receive in return. It could also help you negotiate better payment terms by offering to adjust other framework levers, such as improving delivery times or service levels.
Negotiate staged payments on customer projects
Negotiate a framework that’s closer to your ideal timings. Such arrangements could include staged or milestone payments on longer orders and projects. For example, your customer might pay 25% on order, 25% on delivery and 50% 30 days later – or attach these stages to parts of a project.
Negotiate longer payments with suppliers
Don’t always accept your supplier’s payment terms. Discuss a timeline that works better for you, especially if you have negotiating power – for example, if you are a large customer or have something valuable you can offer in return, such as exclusivity.
Consider invoice discounting or factoring
Invoice discounting and factoring are financing mechanisms that allow you to release funds against unpaid invoices. This dramatically reduces the average time to turn sales into cash, enabling you to reinvest and keep expanding quickly while waiting for customers to pay. It can also allow you to keep taking orders, regardless of size and volume, because you know you will have cash to fund the sale.
The faster you grow, the better invoice discounting works. The downsides are that it can be expensive and if your sales slow, it could lead you into financial difficulties.
Get in touch
For help with managing your business and personal finances to free up cash, get in touch with us today.
Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.
SJP Approved 19/10/2023