Smart Strategies for Optimizing Working Capital
The COVID-19 pandemic, followed by the subsequent economic downturn has hurled countless companies into difficult working capital situations. When policies first shifted to bolster an economy that appeared to ground to a halt, strong consumer demand supported by low-interest rates led many businesses to transition from Just-In-Time (JIT) to Just-In-Case (JIC) procurement strategies, prompting higher-than-normal inventory levels. When consumer spending declined dramatically in 2022 and 2023, it resulted in revenue drops of as much as 30%. In some cases, the decline in demand drove a 50% drop in inventory turnover rates, leaving companies with far too much inventory. Rapid inflation and rising wages further eroded profit margins, and a significant increase in interest rates exacerbated the financial strain, leaving many companies with excess inventory, slow-paying customers, and extended accounts payable terms as a means to manage dwindling cash reserves. Banks, too, have been increasingly concerned about companies failing to meet their loan covenants, resulting in tightening credit policies and making it difficult to increase lines of credit or use term debt to finance fixed assets.
In this trying scenario, companies must adopt a multifaceted approach to restore financial stability and optimize working capital.
Business leaders should begin with a comprehensive inventory audit to tackle the issues of excess inventory, identifying slow-moving or obsolete items. Following the audit, markdown strategies or clearance sales can be designed to help liquidate excess stocks. Furthermore, demand forecasting can be enhanced through advanced analytics, and is crucial for aligning inventory levels more accurately with current market conditions. Lastly, renegotiating terms with suppliers to allow for more flexible order quantities and return policies can significantly reduce the risk of overstocking.
Managing accounts receivable effectively has also never been more imperative than it is today. Tightening credit policies and conducting regular reviews of customer creditworthiness can minimize the risk of bad debts. Offering discounts or incentives for early payments is a strategy to accelerate cash inflows while strengthening collection efforts through increased follow-ups and improved communications with slow payers.
Conversely, for accounts payable, negotiating extended payment terms with suppliers can improve cash flow without straining supplier relationships. Developing strategic partnerships with key suppliers can also lead to better credit terms and potentially more favorable pricing. A payment scheduling system to prioritize critical payments should also be implemented to help manage cash outflows more effectively.
Operational efficiency is fundamental for controlling and reducing costs. Identifying and eliminating inefficiencies in operational processes or removing positions that are not currently mission-critical will have a huge impact on increasing efficiency. Conducting a comprehensive review of all expenses, and then cutting non-essential costs is crucial. While cost-cutting poses a risk to company morale and culture, doing it once, with a comprehensive plan will often improve confidence once the cycle is over. In my experience, employees tend to know that costs need to be reduced, and they are just waiting for management to act. This anxiety is equally straining on morale and culture. Employees will rise to the occasion if management takes the correct steps to cut costs with integrity and transparency.
Companies in a strained working capital situation always need more liquidity. Proactively engaging in discussions with lenders to renegotiate loan covenants or seek temporary waivers can help avoid breaches. Financial advisors, such as Turning Point, help clients restructure existing debt and secure more favorable terms or consolidate loans. Exploring alternative financing options including factoring, asset-based lending, or supply chain financing can also provide a business with much-needed liquidity.
Moreover, companies should set their sights on returning to historical profit margins. The first step to get there is to raise prices. I have seen companies increase prices 20-30% in 2023 and 2024. It is important to thoroughly understand your costs and pricing structure and be able to communicate with customers why the increase is necessary. At the same time focusing on higher-margin products and services or eliminating low-margin products and services can improve overall profitability.
Finally, strategic planning is crucial to optimizing working capital. Developing multiple financial scenarios to prepare for various market conditions ensures agility in decision-making. Focusing on long-term strategic goals, while balancing immediate liquidity needs with future growth opportunities, is essential to success and sustainability.
