Working Capital Management - Part 2/3: Value levers in Working Capital

Active working capital management secures liquidity through the effective use of available funds and offers great opportunities to increase existing values. A three-part blog series shows how a company's capital commitment and cash conversion cycle can be determined and which measures can be taken to affect these positively.

Part 2/3: Active management of receivables and liabilities to increase liquidity

In the first part of this series, the Net Working Capital (NWC) and the Cash Conversion Cycle (CCC) have been examined in more detail.

The key facts of part 1 summarized:

  • "Net Working Capital” provides information on the short-term capital commitment of a company.
  • The Cash Conversion Cycle (CCC) represents the average number of days it takes the company to convert capital outflows for purchasing stock items into capital inflows from trade accounts receivable.
  • The CCC is calculated as follows: CCC = DIO + DSO – DPO.
Part 2/3 provides information on the active management of receivables and liabilities to increase liquidity:
  • If the average collection period is less than the range of liabilities, a company can settle the liabilities using the payments made by the customers.
  • Improving the invoicing process as well as the dunning system help to track and actively manage payment terms, and in this way, to increase available liquidity.
  • Active management of the accounts payable may extend the term of liabilities and increase the company's liquidity.

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If the average collection period is less than the range of liabilities, a company can settle the liabilities using the payments made by the customers.

The term "Days Sales Outstanding" (DSO) refers to the number of days that elapse between the time of invoicing and receipt of payment in the bank account. A quick settlement of the receivables and thus a low DSO have a positive effect on the liquidity of a company (cf. Fig. 1), whereas a high DSO implies slow payment of the customer's invoices.

The figure “Days Payable Outstanding” (DPO) indicates the time a company needs on average to settle its trade accounts payable (see Fig. 1). From the working capital point of view, a high DPO reflects a lower capital commitment and thus more available liquidity.

If the DSO is less than the DPO, the company can settle the liabilities with the payments from the customers. Otherwise, the company must pre-finance the repayment of liabilities using its own liquidity or through loans, which can result in liquidity bottlenecks. These bottlenecks can be counteracted by optimizing business processes related to the DSO and DPO.

Figure 1

according to Seppelfricke, Peter, Unternehmensanalysen, 1st edition 2019, chap. 2 Finanzanalysen, p. 140
Improving invoicing and dunning can increase a company's liquidity

By means of an active management of receivables, it is possible to shorten the DSO and thus improve a company's liquidity situation.

Measures to optimize the DSO are:

  • (Re) negotiation of payment terms: Payment terms can be renegotiated with existing customers. With new customers, attention should be paid to the shortest possible payment term right from the start. In order to create an incentive for customers to pay invoices promptly, a discount can be granted.
  • Prompt invoicing: If the invoice is issued immediately after the service has been provided, the company favors receipt of payment as early as possible. Software solutions can help to optimize the invoicing process and to ensure automatic tracking of the payment periods.
  • Active dunning: If, in addition to prompt invoicing, attention is also paid to regular checking of the punctuality of incoming payments, payment delays are noticed immediately and can be resolved directly.
Active management of the accounts payable may increase the company's liquidity.

Increasing the DPO also releases liquidity. Measures to increase the DPO are:

  • (Re) negotiation of payment terms: With new contracts, care should be taken from the start to agree payment terms that are as long as possible. If necessary, it is also possible to renegotiate existing contracts with the contractual partners. A compromise with regard to the purchase price or other contractual points can strengthen your own negotiating position in order to stretch the payment period. 
  • Maxing out the payment terms: In order to keep means of payment in the company for a long time, invoices should be paid as late as possible. However, care should be taken to ensure that the relationship with suppliers / creditors is not negatively affected by stretching the payment term.

Active management of receivables and liabilities can reduce a company's capital commitment and liquidity requirements.

In the next part of our series on value levers in working capital, the time of inventory turnover and in particular the key figure “Days Inventory Held” will be examined in more detail. In addition, measures to optimize the CCC and the net working capital will be shown..

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