Effective cashflow management is key to business success. Operating working capital needs to be kept as low as possible, even down into negative values, in order to improve the cash position. To control the stock level, the purchasing volume needs be fine tuned to the latest sales trend and forecast.
When you’re working on reducing the capital locked up in inventory, start by keeping inventory on hand levels low and ordering just-in-time inventory to meet your customer demands.
Ideally your customers should be paying you before you need to pay your suppliers. The advantages are obvious: When your working capital is negative, you do not need to tap into your bank account when procuring inventory. As long as you’ve not paid your suppliers for the inventory on hand, you can cash in when it’s sold to the customer. Finally, you only pay the supplier only after you receive the cash from the customer. This way, you would receive a cash benefit from the supplier and have a positive cash balance. In this scenario, a growing business would not feel the strain of pre-financing a larger inventory level, as the inventory would be pre-financed by the suppliers.
To unlock capital tied up in your inventory, you need:
- Supplier payment terms that are longer than the payment terms of the customer
- Inventory turnover that is faster than the payment term difference
An effective way to control your inventory levels is to introduce maximum stock levels that keep the working capital low or even negative while balancing the benefits of lower cash-out with the potential reduction of some supplier discounts.
Reducing Stock Levels
Inventory management plays an important role in reducing working capital, as the goal is to sell out the inventory to the minimum stock level before the supplier needs to be paid. However, you also need to be careful of overselling, as this can cause you to end up in an out of stock situation.
With an inventory management solution like TradeGecko, you’ll have access to sales intelligence reports that can help you decide on the optimal inventory levels for your product based on your sales history. Once you’ve set your optimal stock levels after taking customer demand and safety stock into account, the next step is to calculate your reorder points to ensure you’ll always have enough stock on hand for your customers.
There is always the temptation for wholesalers to increase their order sizes for a supplier discount or rebate, which is why it’s important to set maximum stock levels for your products.
To measure the benefits of the available cash, you have to look at your financing situation. Let’s assume that you have a company loan of $1 million. If you can reduce the stock level on average by $100,000, you can reduce the loan to $900,000. That way, you save the interest rate on the $100,000 as you do not need to finance the stock. If you keep the loan at $1 million or have no loan at all, you have just increased your cash position by $100,000. You can now use this money to invest in other opportunities for growing your business that will earn you more profit.
In case you have an attractive investment opportunity but financing resources are used to the limit, you can look into freeing up cash from careful stock management to finance these investments. However, if you choose to maintain high inventory levels, you’ll face the opportunity costs of losing out on these growth opportunities. At the same time, additional side effects may complicate the assessment. For example, reducing the order size may result in higher handling costs even as it reduces the warehouse costs.
As a business owner, you need to evaluate your specific business case and make sure the benefits outweigh the additional costs when deciding.
Reducing Order Size
Some suppliers require a minimum order quantity and this quantity could already be more than needed. In this case, you should start negotiating better terms to improve your cash flow management. When faced with a minimum order quantity, try to negotiate longer payment terms for this specific order or splitting payments in line with the expected sales of the product.
A side note on negative working capital
Negative working capital has many benefits to a business in stable times and times of growth, but it can become a risk when customer demand is shrinking. If sales are declining dramatically and aren’t anticipated in a reduced order size, you will face an increase in working capital and an increase to your expenses.
At the same time, slow sales also result in a cash drain, leaving a business stuck with little available cash due to capital locked up in stock. For a B2B business, the absolute amount of working capital can be huge and the potential outflow of cash, significant. So as a business owner, you need to be prepared for this risk and have alternative financing options ready to minimize the impact to your business.
It is essential to manage your stock level according to your individual sales cycle and financing capabilities. If you place large orders to cash-in supplier discounts it might not be to your overall advantage.
The best starting point is to find out the stock level that really supports your business at minimal cash out. Only afterwards you might consider extending an order and receive a supplier discount, because now you are aware of the extra cash required to get this discount. With this preparation you are in the position to reduce the working capital and improve your cash flow. That way, you can put yourself in a better position to control your spending - get discounts or expand the business.
This is the second article in a series by our guest author Thorsten Ohm. Click here to read his first article: How to build a KPI dashboard for inventory management
About the Author:
Thorsten Ohm is a cofounder of Waypoint Ventures. He has 20 years of international experiences spanning across many geographies, where he has set-up organisations and developed businesses. As a senior corporate executive and a board member he is experienced in growing businesses organically and via M&A. Waypoint Ventures helps companies to accelerate their growth, improve their performance, and enter new businesses or markets.
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