The CFO'S Perspective

How to Improve Working Capital in Manufacturing Operations

Manufacturing Operations A note with the words “working capital” alongside a calculator, magnifying glass, and a pen surrounded by business iconsManaging consistent working capital provides the resources needed to achieve organizational objectives and execute on the company’s strategic vision. In this way, working capital ensures business continuity for manufacturers and acts as a determiner of success. When cash is managed properly, a manufacturer will not only have the resources needed to keep operations running on schedule but also generate the long-term capital needed for major expenses like equipment replacement and facilities upgrades.

However, in a manufacturing setting, working capital is typically harder to manage than other industries. Manufacturing has a number of oddities that complicate their working capital formula and make management more challenging. Furthermore, inventory risks, high operating costs, reliance on manual processes, and frequent payment delays can all put strain on their working capital. The result is a perfect storm of cash flow management difficulties for manufacturers.

For more information on how to manage working capital in manufacturing, please review our guide to improving working capital:

Why is Working Capital So Important?

In the PwC whitepaper Pressure on The Production Line, Cara Haffey, an Industrial Manufacturing Leader, summarizes,

“Manufacturing companies should not regard their working capital simply as an overdraft, but should focus on it as the first option for funding investment in their business, without the need to access additional funding or put pressure on cash flows. For many manufacturers, the cash for investment in new technologies is already sitting in their business as working capital. It’s time to release it.”

Her colleague Daniel Windaus, Working Capital Partner, further explains,

“Looking across all industries, manufacturing is a sector where the link between working capital, returns and investment is particularly strong. To compete effectively and generate higher returns on a sustainable basis, manufacturing companies need to keep investing in their business. Good working capital management frees up cash to fund this investment. So there is often a direct correlation between better working capital management and higher returns and investment.”

Working capital is the lifeblood of a manufacturing organization because improving it leads to:

  • Increased cash flow
  • Greater business agility
  • Increased liquidity
  • Increased solvency
  • More effective inventory control
  • Greater leverage for negotiating with suppliers
  • Better management of accounts payable (AP)
  • Greater attractiveness to investors
  • Expanded funding options

Challenges for Manufacturers

One of the most difficult things for manufacturers to manage is inventory. An excess of inventory can tie up too much working capital while insufficient inventory can stifle growth and lead to delays that damage existing customer relationships. As a result, managing inventory is a key challenge for manufacturers looking to increase working capital because pinpointing the right level of inventory at any given time is a delicate balancing act. Each manufacturer will need to do extensive data analysis to help inform inventory decisions.

Additionally, high manufacturing operating costs make managing working capital difficult. Many manufacturers rely on thin profit margins to generate revenue, which makes any change in operating costs difficult. As expenses around things like R&D, rent, equipment, sales/marketing, and other operating costs increase, working capital dwindles. While other industries may be better able to absorb these added costs manufacturers typically find it harder to do so. Looking for ways to reduce operating costs without sacrificing profitability is an essential part of preserving manufacturing profit margins and increasing working capital.

As is the case with any industry, customer payments will also significantly affect working capital. Late payments will have a negative effect on cash flow, as will poor accounts receivable (AR) practices. What makes this especially challenging for manufacturers is when big accounts are being lax with their payments. Many manufacturers work with a more limited customer base because they are providing their customers with ongoing orders or bulk purchases. When even one key account breaks their payment agreement the financial strain that this places on the manufacturer can be significant. To improve working capital manufacturers must adopt standardized payment terms, send invoices promptly, give our credit sparingly, and incentivize timely payments. Some manufacturers do this by offering a discount for early payment or shortened payment terms, while others impose penalties for late payment. Both approaches can be successful.

Complicating matters further, daily accounting functions (like processing AR) are being done manually at many manufacturing organizations. The paradox in manufacturing is that while the line may utilize technology extensively and be highly automated, back office functions are not nearly so eager to modernize. As a result, they are far more labor intensive, reducing efficiency and greatly increasing costs. Manufacturers that want to improve working capital should look for ways to streamline operations both in the manufacturing process itself and also behind the scenes.

Working Capital Management Strategies

Improving AR Processes

Manufacturers are always looking for ways to improve their processes across the organization to gain efficiency, reduce expenses, and increase margins. One of the most important processes that must be improved is collecting AR. Manufacturers that can increase how quickly they get paid will inherently have more working capital to invest in the business. But moreover, manufacturers that can get paid more quickly can turn around and pay their suppliers more quickly, strengthening their position in the market and potentially earning them better pricing, additional support, or other premium upgrades. These kinds of opportunities fuel business growth.

For this reason, some companies choose to sell their AR to recoup missing revenue from their slowest paying accounts. (For more information on this strategy, visit our article: Cash Management & Selling AR) Other manufacturers will automate their AR processes to reduce their labor needs and speed up the process. And still others will offer discounts to customers to incentivize early payment. But regardless of the approach, prioritizing AR collection can go a long way in improving working capital.

Focusing on Current Assets

When a manufacturer converts current assets into cash it increases working capital, which is why proper inventory management is so critical. A manufacturer must be keenly aware of its current ratio, which is its current assets compared to current liabilities, to understand how well it is poised to meet its short-term obligations. Manufacturers that are doing a good job of managing their working capital will have a current ratio that is high enough to indicate that they can meet their obligations but not one that is so high that it indicates that they are sitting on cash instead of investing it back into the business. Typically, an appropriate current ratio for manufacturing would be between 1.5 and 2. Without tracking this important metric, a manufacturer will lack the benchmark needed to assess whether they are using working capital appropriately.

Developing a Cash Culture

Daniel Windaus, with PwC UK, explains how manufacturers can develop a “cash culture” when he says,

“All too often, there’s a perception in manufacturing companies that bringing money in and improving working capital performance are solely the job of the Finance function. In fact, these should be part of everybody’s role in every area of the organisation, from procurement to operations. To improve working capital management substantially and sustainably, the workplace culture must reinforce this shared responsibility.”

Management and executive leadership must promote this vision and encourage their teams to share the responsibility for improving working capital within their own spheres as well as across the entire value chain.

The Unique Working Capital Formula for Manufacturers

To understand which approach (or which combination of approaches) will best improve working capital at an organization, leadership must understand the nuances of how manufacturing working capital is calculated.

The general working capital equation is: Working Capital = Inventory + AR – AP

However, for manufacturers it is more complicated because “inventory” does not simply include finished goods. In manufacturing it also applies to raw materials as well as any work in progress (WIP). Understanding that, working capital for a manufacturer can calculated using the following adapted formula: Working Capital = Raw Materials + Work in Progress + Finished Goods + AR – AP

Manufacturers that are holding onto significant raw materials inventory and finished goods inventory will need to convert theses value into average daily purchases and average daily inventory levels to derive a current working capital estimation. This is especially important if a manufacturer is holding onto 45, 60, or 90 days’ worth of inventory (or even more!). Where raw materials and finished goods inventories are not consistent, forecasts will need to be used to determine how much inventory is likely to be on hand at a given point in time.

The same will need to be done for Work In progress (WIP), especially if the manufacturing work in question is a long process that spans multiple reporting periods. For instance, manufacturers with more customized products may have work in progress much longer than their bulk production counterparts, making daily WIP calculations a crucial component of the working capital formula for manufacturers.

Lastly, daily AR and AP figures will need to be calculated based on customer credit terms and supplier payment terms. This becomes especially important when customer credit terms are significantly longer than supplier credit terms. (As an example, if a manufacturer offers net-30 or net-60 payment terms to their customers but only has net-15 day terms with their biggest suppliers.) Furthermore, variable credit terms can have a significant impact on daily AR and AP calculations, as such the calculations will need to adapt accordingly to ensure accurate calculations.

If your manufacturing operation needs strong financial leadership, reach out to us! We have an experienced team of consulting CFO and Controllers with the expertise needed to help your organization increase working capital, improve financial data analysis, and ensure timely reporting. Contact us today to find out how we can help!

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