Working Capital Optimization: Strategies for Small Businesses

Working capital optimization might not be your first thought when considering the financial health of your small business. But optimizing working capital is key to thriving in today’s competitive market.

The modern era of business requires you to think and move fast, especially when considering supply chain complexities, the drive for increased profitability and the potential for automation to streamline processes.

If you’re looking for strategies to improve the cash flow management of your business, here’s what it means to optimize your working capital — and how you can do it.

What Is Working Capital Optimization?

Working capital optimization is the process of managing a business’s short-term assets and liabilities to maintain liquidity. It’s about finding the perfect balance between having enough cash flow to cover daily operations without tying up too much in assets or being in excessive debt.

The working capital optimization cycle is a financial strategy. It involves understanding and managing the timing of cash inflows from receivables, the cash outflows for payables, and the holding period of inventory. The goal is to reduce the cash conversion cycle, freeing up cash that can be used for other productive purposes within the business.

How Do You Improve Your Working Capital Management?

Improving working capital management involves strategic approaches to the working capital cycle — the process of converting inventory into cash. Below are key areas to focus on:

Understand the working capital cycle. The working capital cycle measures the time it takes for a company to convert its inventory and other resources into cash. A shorter cycle indicates a more efficient business. Understanding this cycle helps in identifying areas for improvement in cash flow management.

Manage accounts receivable. Prompt procurement of accounts receivable is important. To do this, you could start initiatives such as early payment discounts, or implement an invoicing system to speed up collections. A business line of credit or working capital loan are other ways to keep cash on hand.

Manage accounts payable. On the payables side, it’s important to pay suppliers on time to maintain good relationships. However, strategically delaying payments within agreed terms can help maintain cash in the business longer. You can also try negotiating better payment terms and taking advantage of any early payment discounts or incentives.

Manage inventory. Inventory management is a delicate balance — too much inventory ties up capital, but too little can result in stockouts and lost sales. Implementing inventory optimization techniques such as just-in-time (JIT) inventory can significantly reduce holding costs and free up working capital.

Why Is Working Capital Optimization Important?

For small businesses, effective working capital management can mean the difference between growth and stagnation. It ensures that a business has enough cash flow to meet its short-term obligations, such as paying suppliers, employees and other operational costs. This not only safeguards the business’s reputation and creditworthiness, but also positions it to seize growth opportunities without the need for external financing.

How Do You Calculate Optimal Working Capital?

Working capital is calculated by subtracting current liabilities from current assets. The formula is:

Working Capital = Current Assets – Current Liabilities

The working capital optimization cycle, or cash conversion cycle, is then determined by adding Days Sales Outstanding (DSO) and Days Inventory Outstanding (DIO), and subtracting Days Payable Outstanding (DPO).

Working Capital Optimization Cycle = (DSO + DIO) – DPO

However, the optimal level varies by industry, business model and market conditions. It’s crucial to analyze operational needs and forecast cash flow to determine the right balance for your business.

Here’s a deeper look at the three key performance indicators (KPIs) that make up this formula:

Days Sales Outstanding: This metric measures the average number of days it takes for a company to collect payment after a sale has been made. It is calculated by dividing the average accounts receivable by the total credit sales and then multiplying by 365 days.

Day Sales Outstanding = (Average Accounts Receivable/Cost of Goods Sold) x 365

Days Payable Outstanding: This measures the average number of days a company takes to pay its bills and invoices. It is calculated by dividing the average accounts payable by the cost of goods sold and then multiplying by 365 days.

Days Payable Outstanding = (Average Accounts Payable/Cost of Goods Sold) x 365

Days Inventory Outstanding: This measures the average number of days a company holds its inventory before selling it. It is calculated by dividing the average inventory by the cost of goods sold and then multiplying by 365 days.

Days Inventory Outstanding = (Average Inventory/Cost of Goods Sold) x 365

The Bottom Line

Working capital optimization is not a one-size-fits-all process. It requires continuous monitoring and adjustment to align with the business’s operational needs and goals. By understanding and effectively managing the components of the working capital cycle, small businesses can improve liquidity, reduce costs and create sustainable growth.

Effective working capital management is a hallmark of a well-run business and a critical factor in achieving long-term success. It’s also important to keep an eye on the balance sheet and aim to optimize inventory levels and payment processes.

What Experts Say: How Can Small Businesses Optimize Their Working Capital?

Collect fast and pay slow

Collect fast and pay slow. On the front end, you need to be certain that your clients are worthy of credit and that your collection terms are (at a minimum) as favorable as, but preferably better than, your payment terms to vendors. In the middle, be resolute and diligent on your collections and manage payables accordingly. Be aware that in many cases a psychological conundrum is in play with your accounting team. And by that I mean they will oftentimes pay fast and then collect slow in an effort to avoid conflict. But this is the opposite of what you need to do in order to manage working capital well.

John Frank, Founder & CEO
Third Road Management

Consider money market funds

Many small businesses have net 30 days terms with their suppliers. This means you generate revenue and have 30 days before you have to pay your suppliers for the costs required to generate that revenue. This is what creates a positive working capital position and if you have growing sales revenue, your positive working capital position will continue to grow over time.

Short-term money market rates are near 5% and are typically much better than interest rates at banks.

Lou Haverty, Owner
Skid Retailer

Prioritize effective cash flow

My top advice to fellow small business owners would be to prioritize effective cash flow management above all else. This includes not only understanding your company’s cash inflows and outflows, but also implementing comprehensive strategies to maintain a healthy balance between the two. Without a thorough understanding of your company’s cash flow dynamics, it becomes difficult to make informed decisions about spending, investing and expansion, all of which are critical components of business growth and sustainability.

Jon Morgan, CEO & Editor-in-Chief
VentureSmarter