A good barometer of how great the demands of your operating cycle are on your working capital is the 'cash conversion cycle'. This is expressed in number of days and shows how long money is tied up in your business's purchasing, production and sales processes.
The calculation of the cash conversion cycle is based on:
- the number of days' customer credit (DSO – Days Sales Outstanding):
the average number of days that your business must wait for payment after a product or service is delivered.
- the number of days' stock rotation (DIO – Days Inventory Outstanding):
the average number of days that your business needs to convert stock into a sale.
- the number of days' supplier credit (DPO – Days Payable Outstanding):
the average number of days that your business needs to pay suppliers.
The shorter the cycle, the less capital is held in the business process, which allows you to meet your short-term liabilities and expand your activities.
Simplified presentation of the cash conversion cycle
Working capital: far more than just an accounting term
Working capital, also known as net operating capital, presents a picture of the operational liquidity of a business. But there is more to it than meets the eye.
The success of a business actually depends to a significant extent on how it deals with its working capital needs.
The difference between working capital and working capital needs
Within the financial analysis, working capital is just one of the indicators that present a picture of the operational liquidity of a business. It not only affects general management, but also the access to bank credit or the valuation of the business, for example. This is calculated as follows:
Equity capital and other resources in the long term - fixed assets
This allows you to see whether sufficient long-term funds are available to finance the production chain. Where there is a positive result that is indeed the case, whereas with a negative result it is actually the production chain that must safeguard the long-term financing.
It is therefore useful to calculate the working capital needs as well:
Current assets (excluding cash) - current liabilities (excluding financial liabilities)
The result shows the amount the business needs in order to finance its production chain, and may be both positive and negative:
- where working capital needs are positive, the commercial debts no longer cover the short-term assets (excluding the financial). In that case, a business can rely on its working capital. If this is insufficient, it will need additional financing for its operational cycle in the short term;
- where working capital needs are negative, a business can meet its short-term liabilities without any problem. Nevertheless, it is advisable to reduce working capital needs (further).
In short, working capital presents a picture of the operational liquidity of a business, whereas working capital needs represent the amount the business needs in order to finance its production chain.
In other words, it boils down to limiting working capital needs as far as possible, thus increasing liquidity. This is crucial, especially in times of economic or financial difficulty. After all, customers tend to pay later then, while your stocks are increasing and your suppliers are imposing stricter payment terms. As a result, more and more working capital gets 'frozen' in your operating cycle, precisely when circumstances make it more difficult to attract additional financing.
Optimising working capital is not only a question of long-term considerations. In the short term, too, the business can release cash that is not being used optimally, or is being used unnecessarily, more specifically in the purchasing, production and sales processes within the operating cycle.
The working capital and the working capital needs must, above all, be geared effectively to each other. The working capital needs must be structurally less than the working capital itself, preferably with an extra buffer. However, there is no mathematical truth regarding the amount of working capital and working capital needs. Sector, activity and business model can affect this, for example.
4 rules of thumb to get your working capital working for you
Although entrepreneurs are familiar with the term working capital, all too often they fail to use its full potential. This is a mistake, because targeted management of their working capital needs can bring huge advantages, both financially and at an organisational level.
How a business approaches that in practice is obviously closely linked to its own specific situation and the sector in which it operates. Below is a number of general rules of thumb:
1. Analyse your business processes
A logical first step is a thorough analysis of your working capital needs, based on the cash conversion cycle. The idea is to clearly identify the following business processes:
- management of your customer payments
How long does it take before your invoices are paid? Why do some invoices remain outstanding? How aware are you of your customers' financial situations?
- management of your supplier payments
What payment terms are you getting? Do you get a discount if you pay quickly? Do you use advance financing?
- management of your production and stock
How far can you deplete stocks without jeopardising production? Can you shorten the production time in order to reduce the amount of work in progress? Do you work according to the Just-in-Time system or have you decided to go for Economic Order Quantity?
You will then find out where there is room for improvement and how you can shorten the cash conversion cycle. The idea is to reduce your working capital needs and, by doing so – by dealing more frugally with the available capital – increase the return from your general management.
2. Collect faster and better
Adequate monitoring of your accounts receivable is crucial. Relatively small, obvious interventions can sometimes produce a surprisingly big benefit. Here are some tips:
- Monitor the quality of your invoices. A good invoice will quote a correct amount, a payment due date and will be received promptly by your customers.
- Invoice smaller amounts on a regular basis and avoid summary invoices where possible.
- Actively follow up outstanding invoices and find out why they remain unpaid. Is it down to the customer's financial situation or are there other factors to consider? Disagreement over the amount charged or problems with the delivery or sale often cause delays or result in non-payment. By aligning your accounts and services more efficiently, you end up with a win-win situation: satisfied customers and fewer disputed invoices.
- Solutions such as factoring or direct debit are a particularly profitable route to take. These lead to swifter collection without putting pressure on your customers or tightening up your payment terms, which is always delicate in a commercial relationship.
A clear picture
Without an overview of your accounts at home and abroad and of your incoming and outgoing payments, management of your working capital is virtually impossible. So, you need clear, immediately available information and reporting. Different solutions for electronic banking, reporting arrangements with your financial partners and efficient operation of your accounts and bookkeeping will help you considerably here.
Another profitable route is the centralisation of your cash and cash equivalents, which will dramatically simplify both the management and monitoring of these. Often this also offers numerous options in terms of fiscal optimisation.
3. Make optimum use of your supplier credit
Making sure your invoices are paid systematically in order to build up your number of days' supplier credit seems a painless and effective intervention, but it is the least you should do. After all, there is a good chance that the supplier will pass on the charge for the longer payment term in the price you pay for subsequent deliveries. There are a number of better alternatives:
- See whether or not it would benefit you to pay more quickly – in many cases early payment carries an attractive discount.
- Choose solutions that let you pay later without the other party being affected. For example, by relying on lines of credit or working via reverse factoring, whereby the supplier receives an advance on your payments from the bank.
- Negotiate with your supplier for an extension to your payment terms.
Ensure you have adequate protection
Being able to get hold of your funds quickly is just one aspect of optimum management of your working capital. Another is the assurance that your customers will actually pay, while at the same time your business must project confidence to (potential) trade partners. To that end, you can call on the various forms of documentary credit. By engaging credit insurers, you are also hedging the risk of the other party defaulting on payment.
Another important factor, certainly as far as international transactions are concerned, is the exchange rate risk. Although you may know when you are going to get paid, the exact amount depends on the exchange rate at the time of payment. Because the difference between a good and a less favourable exchange rate can have a big effect on your margin, you are better off hedging yourself against possible exchange rate fluctuations.
4. Get maximum performance from your stocks
The financial impact of your inventory control should not be underestimated. Just think about invoices that are outstanding after a faulty or late delivery, or holding on to too much stock of slow-selling products. The advantage of the latter is that you can always deliver promptly, but it does freeze a major part of your working capital. A few guidelines:
- Check your stocks and prices regularly, preferably using a package like Enterprise Resource Planning (ERP) or a web-based application with direct link to your opposite parties.
- A warehouse management system will allow you to retain a good overview of your quick and slow-selling products, so you can adjust your stock accordingly.
- Keep your finger on the pulse of the market so that you can correctly assess demand, and thus avoid stock surpluses or deficits.
- You can also choose a radically different course and outsource your stock management to a logistics service provider.
- Use stock financing to keep cash and cash equivalents available for other purposes.
- Hedge yourself against price fluctuations on the raw materials markets, to protect your margin.
An exercise in balance
Optimising your working capital needs is therefore a continual exercise in balance between your accounts receivable, accounts payable and inventory control. It is a stiff challenge, but essential if you are to increase your financial might and steal the march on your competitors. Get your working capital to perform!
Crowdsourcing: the basics
Are you undecided about the various ways of increasing your offering? Has R&D encountered a technical problem? Perhaps your clients know more.
The concept of crowdsourcing is simple: you call for the contribution of your customers and/or the general public. An approach which is gaining popularity worldwide even though it is not actually new. As far back as 1714 crowdsourcing by the British government led to the invention of the chronometer and therefore a reliable method of calculating longitudinal position at sea.
Three hundred years later the basic principles remain the same: in crowdsourcing you work with a network of individuals and communities within and largely outside the company. They make a contribution in the form of ideas, time, expertise or financial support. This enables new solutions to be accessed and makes realisation of joint projects and optimisation of tasks possible while keeping down costs.
This system is based on exchange, transparency and communication. It also works for all sectors and at all management levels. You should be able to engage a community of designers for your product development for example and choose the best proposal together with the public. Then you will bring it onto the market, possibly even financed via crowdfunding.
The crowd is ready for this
This is certainly no science fiction, as proven by the growing success of the system. It is also the ideal time to get involved with crowdsourcing:
- communicating with the crowd is easier than ever before thanks to technological development, the social media boom and the development of online communities;
- the crowd is straining at the leash: a joint survey by several European universities showed that 54% of Europeans would like to support projects by companies and private individuals creatively and/or financially;
- co-creation, or developing a project together, is hot. The crowd can join in with a project for a whole host of reasons: the necessity for a creative outlet, commercial motives, dedication to society or just for a sense of honour or fun;
- the economy urgently needs sources of financing and innovative projects in order to achieve new growth and to increase competitiveness.
It will definitely take some getting used to as such a system radically changes the way in which a company gathers information, carries out research, produces and even finances projects. At the same time relationships with clients or users change as they evolve into potential colleagues, financiers and ambassadors.
But this does not have to be a threat. On the contrary, crowdsourcing provides you with a unique opportunity to relinquish your traditional methods. You can now look externally for ideas, get feedback from the crowd on ideas developed internally or even combine both approaches. The possibilities are endless.
The dos & don’ts of crowdsourcing
A good crowdsourcing project creates a win-win situation where the initiator and the crowd feel that they are achieving something together. How do you approach that?
In crowdsourcing the 'crowd' component is at least as important as the 'sourcing' component. In order to be successful you must build up this community and win it over. This is where the challenge lies: the crowd is not an anonymous, homogeneous mass but a collection of individuals and sub-groups. You need to seek out and mobilise each one separately. 5 tips for a powerful crowd dynamic:
Take care of the presentation of your project
Your project must appeal. Present it with photos, short films or a clear presentation – vague sketches or a half-baked concept are inadequate. Keep your explanation as simple as possible. After all not every potential funder is a specialist or an engineer.
Also, don't forget to keep your target amount as realistic as possible. Above all do not create the impression that the campaign is an excuse for personal enrichment or that you will channel the money off into other, existing projects. If you work with rewards, ensure that they are original and attractive, divided up into transparent and attainable blocks of financing.
Build your crowd
Look for the suitable crowd and get these people right behind your project. Approach them via all possible channels and assign them various roles: creative or technical input, critical analysis, ambassadorial, ... When doing so keep the threshold as low as possible, within your company as well. It is recommended that you bring as many of your people as possible into contact with the crowd in order to ensure healthy cross-pollination.
Live your project
A project without animation has little chance of success. So be motivated and keep motivating others. Respond to queries, take comments into consideration and intervene where necessary. Remember that participants cannot be squeezed to produce viable ideas. They too must go through a creative process in which they can gradually shape their input. So ensure that they continue to be involved. For this purpose it is necessary to approach each sub-group differently: encourage, win over (again), congratulate, permanently challenge, ...
Keep your campaign exciting
Keep communicating, even if some of the messages may be negative. The greater the involvement you demonstrate, the greater the loyalty of the funders and the greater their willingness to accept delays or problems.
A good dosage is important here. Ensure that news is provided at regular intervals to keep the crowd involved so the attention on your campaign does not fade away.
Your project, your rules
The principle: you decide where you want to go with your campaign while being open to suggestions from the crowd. So you lead the crowd to the desired end product rather than the other way round. Otherwise the outcome may be rather different to what you had hoped. A few examples of how not to do it are the recent – and hastily cancelled – campaigns which resulted in the product name iSnack 2.0’, a chocolate bar filled with mince, or a washing-up liquid with a scent of roast chicken...