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Working Capital Management – Achieving Higher Profitability

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What comes to your mind when you think about the financial performance of a business? Is it the profit/loss given at the last line of an income statement? Although that’s one of the strong measures to analyze the financial performance of the business, it does not offer a comprehensive perspective to base all of your decisions on that single metric. This is due to an inherent limitation of the profit/loss that comes with subjective assumptions, accounting estimates, and adequacy of the transaction-related controls. (wikiaccounting, 2021)

Hence, there is a need to consider cash flow operations which are more objective and lead to enhanced accuracy of the decision making and financial analysis. But, the question arises of how to perform cash flow analysis with perspective to working capital management and how startups/businesses can control their cash flows to achieve higher profitability.

How to perform cash flow analysis with perspective to working capital management

Generally, cash flow is divided into three main categories: operating, financing, and investing activities.

Operating activities are about how businesses manage their day-to-day operations. These operations consume working capital/financial resources. As we understand, interest/dividend is payable on raising debt/equity (financial resources). So, there is a cost associated with raising finance and using it as working capital.

Hence, businesses tend to optimize their operations and streamline their processes so that the length of the working capital cycle decreases.

Working capital cycle refers to a complete process of trade. It involves the length of time required to purchase, hold, and collect receivables from the customers. So, if the business has a shorter working capital cycle, it can complete the trade process in a shorter time to earn higher profit within the business’ working capital cycle and vice versa.

So, a shorter working capital cycle is desirable from the perspective of financial analysis, achieved with the shorter production time, shorter inventory days, shorter receivable days, and higher payable days. It’s important to note that higher payable days is more desirable as it brings financing within the business without any cost (in most cases).

It means there is a direct connection between the performance of operational business activities and the achievement of business profitability. If activities like sales, production, and collection are performed with higher efficiency, there are higher chances of profitability, and vice versa, generally speaking. So, if the working capital cycle is shorter, it leads to a lower cost of financing and higher business profitability. The next question arises how business can control cash operations/working capital to achieve higher profitability.

How businesses can control cash operations/working capital cycle to achieve higher business profitability

Control of cash operations require a disciplinary approach to plan, measure, monitor, and take corrective actions for the cash-related operations. The following actions can be helpful in the effective management of the cash-related functions/working capital.

  • Measure your current cash runway

Cash runway refers to the time your business is expected to sustain without a need to raise finance from external financing sources. It considers opening cash position, expected cash inflow and outflow of cash during a period under consideration (SRJ Chartered Accountants, n.d.).

For instance, let’s say your opening cash amounts to $10,000, the expected inflow is $5,000 a month, and the expected outflow amounts to $6,000 a month. The given cash outline clearly suggests more outflow of cash than inflow. Hence, opening cash needs to be able to support the shortage. However, opening cash is limited and expected to support the business to a specific period called cash runway.

Cash runway in the given case can be calculated as follows.

Cash shortage during a month =cash outflow – cash inflow

Cash shortage during a month = $6,000– $5,000

Cash shortage during a month = $1,000

Cash runway = opening cash/cash shortage during a month

Cash run ways = $10,000/$1,000

Cash run ways = 10 months

The current cash runway is 10 months. This means, in the circumstances specified, the business can sustain itself for exactly ten months without raising finance from external sources (for working capital purposes). So, the strategic decision-making persons of the company must consider the length of the cash runway to adequately plan the cash needs of the business.

In fact, setting cash runway as a benchmark can be a helpful measure to control cash-related performance.

  • A comprehensive evaluation of cash flow in terms of revenue and expenses

If your business has more expenses than revenue, it can be taken as an alarming sign; the situation is termed as ”burning cash”. So, there is a need to reduce the cash-burning rate that can be achieved with implementable smart moves to enhance revenue.

For instance, finding a new market to sell an existing product, implementing smart marketing tools, and intelligent changes in the product design can lead to higher sales and increased revenue.

  • Speed up recovery function for the accounts receivables

Making profitable sales is not enough for the successful running of a business. The cash needs to be ultimately realized for successful operations. Otherwise, there may be actual losses behind the profit.

For instance, if the business profit amounts to $2,000 and the expected bad debt to be recorded in future for the current period sales is $2,200. It means there is a net loss of $200. Hence, there is a need to ensure the efficiency of the collection; otherwise, an apparent profit might be a loss in reality. To increase the efficiency of the collection, the business needs to optimize the process of credit approval, formation of credit policy, invoicing, following up, and collecting the cash.

  • Work to enhance gross profit (more relevant for manufacturing business)

One of the ways to achieve higher gross profit is by increasing the price of the product. However, that might not be feasible in a competitive economic environment. So an alternate approach can be to control direct costs.

The biggest secret of controlling direct cost lies in the fact that if there is a higher gross profit, the business has space to offer early payment discounts while maintaining net profitability. Hence, working to enhance gross profitability can be an excellent approach, especially in manufacturing businesses. Likewise, steps to decrease direct costs involve optimizing a production facility that leads to shortening of inventory days and effective management of working capital.

 

Product sorting with respect to profits (ranking for the products, applicable in case of multiple product portfolios)

Product sorting in terms of higher profit is one of the most important strategic tools. It helps identify the products/processes that add maximum value in dollars. Once higher-margin products are identified, business resources need to be allocated accordingly. This helps to ensure the maximization of business profitability.

 

Improve marketing function

Some people think marketing expense is just a negative number in the financial statement. However, that’s not true in all cases, dare I say in most cases. There is a strong need to connect marketing expense with sales growth/additional revenue.

For instance, your marketing expense for the month amounts to $1,000, and you’ve generated sales of $3,000 directly as a result of the allocated marketing expense; that $1,000 is now the cost of sales. It means a return on the ad spent is positive as you have achieved additional sales amounting to $3,000 and profit $2,000 ($3,000-1,000) against marketing expenses of $1,000. The net margin is positive and improves the business margin.

So, why not double marketing expenses from $1,000 to $2,000 to achieve even higher profitability. However, you need to consider other aspects of business management like production threshold, demand, supplies, economies of scale (volume discount), etc.

 

Additional steps to improve working capital management

Cash flow forecasting

The purpose of cash flow forecasting is to identify gaps or surplus generated by the business operations. If there is a gap, it helps to timely control cash flow or look for external financing. On the other hand, if there is a surplus, planning can be done to invest for additional income.

Send electronic invoices to the customers.

Electronic invoices speed up the process of sales, receivables, and receipts. The delay in sending invoices adversely impacts the collection as there can be extensive procedural formalities at the customer’s end. Hence, an electronic invoice can lead to enhanced collection processes.

Dynamic discounting for the customers

Cash discounts on the payment of invoices can lead to an early collection of the funds. Although there may be compromise on the net profitability, you need to balance between liquidity and profitability. (Taulia, n.d.)

Conclusion

Liquidity or cash flow management is one of the important aspects of analyzing business performance. Generally, financial performance is assessed with profit/loss. However, that’s not a comprehensive metric on which to justify all of the decisions of a business. There is a need to analyze working capital management and ensure the working capital cycle is completed in as short a time as possible.

Your working capital cycle can be shortened with certain steps. These steps include but are not limited to analyzing product profitability, optimization of the production processes, enhancement of the gross profits, and improving marketing efficiency. Likewise, additional steps include cash flow forecasting, sending digital invoices, dynamic discounting, etc.

I hope you enjoyed the read. Hit me up and let’s keep the conversation going! I read all the feedback you send me. Also, feel free to throw at me topics you’d like to read or hear my thoughts on. You can always head to my Calendly to schedule a quick chat by going to calendly.com/maxwellampong. Or connect with me your own way through my Linktree: https://linktr.ee/themax.

These are all facts. And this has been an opinion piece.

Have a blessed week!

 

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References

SRJ Chartered Accountants. (n.d.). Established Businesses and Burn Rate. Retrieved from SRJCA: https://www.srjca.com/burn-rate-and-cash-runway-calculator/

Taulia. (n.d.). What is working capital management? Retrieved from Taulia: https://taulia.com/glossary/what-is-working-capital-management/

wikiaccounting. (2021, 12 16). Accounting Profit: Definition, Example, and Explanation. Retrieved from wikiaccounting: https://www.wikiaccounting.com/accounting-profit/

 

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Dr. Maxwell Ampong is the CEO of Maxwell Investments Group, a leading supplier of impact products & services and ICT worldwide. He is also the Co-Founder of The RIO Corporation, connectors between impoverished communities and impact solutions worldwide. He writes about trending and relevant economic topics, and general perspective pieces.

 

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