The year 2020 marked the highest-level Working Capital Index in 10 years resulting from the Covid-19 pandemic, reported J.P. Morgan. The findings highlight how real-world events impact inventory levels and the availability of working capital.
Working capital is defined as inventory, debts, cash, and cash equivalents. A business needs working capital to be able to run its business and withstand volatility in the economy.
In 2020 and 2021, real-world events had a significant impact on inventory levels and working capital, according to the report. First, in 2020, companies conserved cash as they cut down on expenses and halted capex and share buybacks. Then in 2021, as the pandemic receded and recovery ensued, demand spiked, causing the S&P 1500 companies to experience a 20% increase in sales and a corresponding reduction in inventories. While turnover due to sales is good, there were other more negative impacts on inventory. Combined with high demand, there were supply-side disruptions and logistics bottlenecks, leaving companies with less than desired inventory levels and the need to deploy working capital more effectively.
Finding the right balance between inventory and the other components of working capital is important. Overstocking — having too much inventory — reduces the working capital available for other types of current assets. The business won’t have enough left to extend credit to customers. Overstocking also results in increased carrying costs for inventory.
On the other hand, understocking is damaging as well. Having too little inventory can cause a loss of profit if the demand for the product surges. Let’s look at how optimizing inventory can increase working capital.
How can optimizing inventory increase working capital?
According to J.P. Morgan, “Companies can improve their working capital by effectively managing the individual components of their [cash conversion cycle] CCC via reducing inventory levels (decreasing DIO [days inventory outstanding]), extending payment terms with suppliers (increasing DPO [days payable outstanding]) and speeding up collections from customers (shortening DSO [days sales outstanding]). As a general rule, the lower the CCC, the better the working capital efficiency.”
Let me explain further.
- Cash conversion cycle (CCC)
Cash conversion cycle refers to the number of days a company takes to convert inventory purchased to cash by selling products. It is an indicator of the efficiency of working capital management. Fewer CCC days represent higher working capital efficiency.
CCC = DSO+DIO-DPO
To maximize working capital efficiency, the company should manage all three categories:
- Reduce debt period.
- Reduce inventory holding period.
- Increase credit period.
- Days sales outstanding (DSO)
Days sales outstanding (DSO) is the average number of days a company takes to receive the money from goods sold. Basically, it’s the debt turnover ratio. The idea behind the concept is that working capital that is tied up in debts will not be available for buying inventory. Higher DSO will automatically reduce inventory as the company will fall short of money.
Depending on the industry you work in, allowing customers a few days to complete the payment is a normal practice. Sometimes, businesses even allow longer credit periods. The purpose behind extending credit is to increase sales. However, one should remember that it has an inverse relationship with the investment in inventory. Thus, the tact is in balancing the two.
- Days inventory outstanding (DIO)
The number of days for which the company holds products before selling them is called days inventory outstanding (DIO). Obviously, having more turnover of your inventory indicates that you are selling products and converting your physical goods to cash.
- Days payable outstanding (DPO)
As the days taken by your customers to pay the outstanding amount affects the effectiveness of working capital utilization, so do the days you take to pay your creditors. If your creditor gives you more days to pay off your debt, you will be able to improve your working capital efficiency. You will be able to increase your inventory.
Generally speaking, getting the balance between inventory and working capital right includes tying forecasts into sales and operations planning. You should use statistical modeling and predetermined service levels to set appropriate inventory levels for every customer and every product. Reducing inventory can help an organization save precious resources and improve working capital efficiency. This is especially true In an uncertain economic climate. Reducing inventory can help in the following ways:
- Cash availability: As a business owner, you must know that when circumstances are rough, having available cash reserves will help you to navigate in an efficient manner. Cash is essential in salary/wages payment, machinery maintenance, and basic survival needs. If your working capital is tied up in inventory, you might not manage to convert it into cash instantly. Therefore, inventory reduction is advisable in these situations.
- Debt reduction: Investing working capital in inventory will reduce the amount available for lending to consumers. In these times, when the world is facing rising prices of goods and services, one way to sell your goods is by extending credit to your customers. By providing more credit to customers, you can improve your turnover.
- Reduction in payables: Borrowing from banks has become pricier in 2022 with increases in the federal interest rate. If you invest too much in inventory, you might have to borrow funds from banks and pay higher interest, taking on more financial risk. Secondly, suppliers may also charge higher prices for extending their credit to you. Having more inventory means higher payables. Reduce your inventory to optimize your working capital.
Optimize inventory with Cin7
Cin7’s inventory management system comes with analytical tools. The reports and forecasts provided by the software are accurate and reliable. You can get insights into your inventory and predict future scenarios. You can optimize your inventory levels to ensure minimum inventory without having to face stockouts.
In conclusion, your company should evaluate, calculate, and manage your working capital and inventory to optimize your operations in both the best and worst of times.