Deep Dive: Effectively Managing Working Capital & Cash Flow

Within any organization, the flow of capital and its impact on investments and operations can be unpredictable. When business owners, tribal council members, and nonprofit leaders better understand the intricacies and affects of working capital and cash flow, they can capitalize on opportunities for their organizations. REDW’s Client Advisory and Accounting Services (CAAS) advisors are taking a deep dive into the mechanics of effectively managing working capital and cash flow.

Common Elements of Working Capital & Cash Flow

Understanding your working capital and forecasting cash flow are advanced tasks that are critical to the ongoing financial health of your organization. For both working capital management and cash flow forecasting, it is important to begin at a high-level and then drill down to identify and record more detail. Doing so, you’ll first capture foundational categories, then refine your analysis as you consider additional factors. Nuances specific to your industry, Tribe, business structure, and business lifecycle should also be factored in as appropriate.

Timing and frequency are core considerations in both working capital and cash flow management. You can empower your ability to make more informed decisions by properly recording when activity has, or is, expected to occur. This can also be the most difficult factor to predict, so we always start with what we know, then proceed to estimate, then refine our estimates as we learn.

Let’s Dive In: Working Capital Management

Working capital is the collection of an organization’s accessible short-term resources that are available after the short-term liabilities are paid. Working capital management is the process of planning and optimizing the use of an organization’s current assets in the most beneficial way, while considering both its risks and opportunities and weighing these against current liabilities. Each element of working capital has a direct impact on the cash flow and operations of a business. So, ensuring that each of those areas is individually assessed can make a significant difference as to which decisions you make.

Working Capital Formulas

The simplest working capital formula:

The drilled-down working capital formula:

Components of Working Capital

To manage working capital, you need to evaluate each component and consider the timing of when activity occurs to identify opportunities. Also, be mindful of existing contracts and payment terms. Try asking yourself the following questions:

Accounts Receivable – When will we collect balances? How quickly are more transactions added? Should we increase collection efforts, even if it costs to do so? What accounts should be written off? Do we have a sufficient reserve to cover bad debt?
Accounts Payable – Are we capturing early payment discounts? Should we negotiate for better credit terms with our vendors? Is our system set up to pay accounts when due, rather than upon receipt?
Prepaid Expenses – Are we negotiating up-front payments and spreading the costs appropriately? Can we take advantage of paying costs in advance when we expect them to rise in the future?
Inventory – How many days of inventory do we maintain? Can our suppliers and the supply chain support us if we were to carry less inventory? Are we recording spoiled, damaged, lost, stolen, or otherwise unsellable inventory in a timely manner?
Investments – How well are we managing liquidity, risk, and investment income? Are we ensuring that our investments are protected, but also available for other uses?
Credit Cards and Lines of Credit – Are we actively deciding whether to pay minimum payments or to pay off balances? When are the minimum payments due? What is the cost of carrying a balance? Do we have an open line of credit if we unexpectedly need it? Are our credit vehicles integrated into our cash balances so that we do not carry balances when unnecessary?

Let’s Dive In: Cash Flow Management

Typical cash flow statements divide cash flow into operating, investing, and financing activities. While these statements are useful at a high-level, developing a cash flow management plan—or cash flow forecast— involves envisioning future cash flow needs and obligations to capture opportunities and avoid unnecessary risks for the organization.
When creating a cash flow forecast or evaluating data you have received, your objective is to have sufficient and accurate information for making decisions that affect your organization. While global, national, and regional economic situations should be considered, managing your own economy must be the focus of your plan. Outside factors can—and will—impact your plan and the decisions you make, but how you respond to them is within your control.

Cash Flow Forecast Formula

Forecasting your cash flow needs begins with your current balances and obligations. Look at prior cash flow activity and consider separating out recurring from one-time activity. Find out if there are ways to speed up your evaluation, such as obtaining trend reports from your payroll provider.

The simplest cash flow formula can be gathered from bank statements:

A more complex cash flow formula can be as follows:

As shown above, measuring cash flow can be very complex, even before forecasting.

“All Models Are Wrong…”

In 1976, British statistician George Box coined a helpful phrase, “All models are wrong, but some are useful.” The goal is to create a model that identifies actionable shortages or surpluses of cash, not to accurately predict the cash balance at the end of your forecast period. Release the temptation to achieve perfection, and focus on feasibility.

Emphasis of Cash Flow Forecast

Beyond looking at categories from a working capital perspective, three specific areas should be reviewed in detail: payroll disbursements, vendor disbursements, and customer revenue deposits. These areas contain both fluctuating and recurring activity, and measuring them correctly within a cash flow forecast can require nuanced approaches.

Payroll Disbursements – Review historical activity, seasonal trends, and headcount. Timekeeping entries and salary changes can provide data to anticipate increased staffing for holidays as well as projections for commissionable bonuses. Your payroll provider may be able to assist in predicting your payroll.
Vendor Disbursements – Review historical information to identify cycles of recurring payments and their frequency. Include outstanding checks that have not yet cleared, invoices payable, and known changes. If ACH (Automated Clearing House) payments are made to electronically pay authorized vendors, ensure their activity is included within your forecast. First focus on your largest vendor relationships and identify what drives volume.
Customer Revenue Deposits – Evaluate patterns reflected in bank statements for cash and electronic deposits, existing accounts receivable balances and their due dates, as well as any contracts and agreements that obligate payments to you. Identify what drives revenue for your organization and how you convert revenue to cash. Your largest customer relationships may be easiest to predict and have the greatest impact.

Less frequent—but equally important—cash flows include owner or investor distributions, non-routine tax payments, and capital expenditure outlays, among many more.

Updating your forecast weekly is ideal, but monthly may be more manageable for some organizations. Plan to produce and monitor a six week forecast initially, then extend it to thirteen weeks when you’re confident that all major factors are being considered.

Remember, the goal of cash flow forecasting is to provide enough detail to be useful to determine whether an action should be taken. When a shortage of cash is identified, the cause should be noted and a proactive decision made on whether to secure additional funds or to rein in expenses. If a cash surplus exists, decide if retaining the surplus, investing the funds, paying off debt, or securing an asset is optimal.

Streamlining Your Working Capital or Cash Flow Management Process

Building or refining a working capital or cash flow management process can easily feel overwhelming, but you don’t have to do this alone. REDW’s Client Accounting and Advisory Services team is ready to partner with you and your team to streamline your working capital management and cash flow forecasting, as well as provide supportive accounting and finance resources to your organization. We understand business, gaming and hospitality, tribal, and nonprofit operations, and the unique challenges tribal leaders face.