Working Capital Optimization in Small and Medium Enterprises

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Abstract
This paper consists of literature review on working capital optimization in small and
medium organizations. It discusses the effect of capital optimization on small medium enterprise
and its role in the success and profitability of the company. There are also views of various
authors on methods of optimization and the outcomes of working capital optimization for SMEs.

Literature Review
There are various definitions of small and medium companies in different parts of the
world. Bolton committee defines small/medium business according to the respective industry
such as in manufacturing it should have 200 or less employees, in construction number of
employees should be 25 or less and in retail business turnover should be 200,000 or less
(Bolton, 1971). In USA Committee for Economic Development (CED), small business has two
of the four following conditions (Sunday, 2011):

Managers are usually owners

Capital and ownership is of an individual or small group
Operations are taken out locally
Relative size s small when compared to biggest unit in the industry.

According to United States of Americas Small Business Administration defines small

business to be independently owned business having $8 million annual sales (services), $7.5
million annual sales (retail) and $22 million annual sales in wholesale business. Where, in
manufacturing industry average number of employees in a year is 1500 employees (Sunday,
2011). In Japan, it is defined according to the type of industry; in manufacturing industry, total
capital is 100 million and number of employees are 300. While small enterprise in wholesale
business has 30 million paid up capital and 100 employees (Sunday, 2011).
The National Council on Industry (Nigeria) simplified the definition of industrial
enterprise. 1996 the definitions were revised in the following shape (Sunday, 2011):
1. Cottage-scale industry has total cost i.e. including working capital but excluding cost of
land is 1 million with more than 10 workers.

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2. Small scale enterprise will have total cost of below 40 million but above 1 million
and 11-35 numbers of workers.
3. Medium-scale eEnterprise will have total cost of more than 40 million but less than
150 million with 36-100 workers.
4. Large scale industry has enterprise with a total cost of 150 million above and 100
workers (Nnanna, 2005)
K.J. Sunday (2011) conducted a research on working capital of small and medium enterprise.
The study showed that in Nigeria, small companies had weak financial positions. The main
source of financing there operations was credit and this credit facility mostly came from account
payables. Also, from these companies, some of them became insolvent and failed due to lack of
financial assistance of financial institutions such as banks. Due to poor record keeping, the flow
of cash was not properly monitored thus the poor working capital flow made them inefficient and
incompetent. Study showed that small companies failed miserably mostly within two years of the
launch of their business. All of this happened due to unproductive cash flow system, poor record
keeping and thus failing of working capital and eventually the company.
Working capital is commonly known as the fund required by the company to run day-to-day
expenses of the business. For finance manager it is known as the the portion of capital of any
organization required to meet the salaries, wages, raw material purchase, supply chain and
recurring operating expenses. It is easy for any organization to calculate the fixed capital i.e. the
cost of machinery, computers, plant and transportation, but working capital is a variable and
dynamic (Joseph, 2006). Park & Gladosn (1963) elaborated the definition of working capital as
surplus of current assets over current items that are owed to company employees or creditor.
Current assists in this case are considered to be cash, account receivable and inventories etc.
whereas, items owed are salaries, wages, accounts payables and government taxes etc.

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(Bhattacharya, 2009). Working capital is considered to be the largest source of cash. If the
company applies more strategic approach towards working capital then it is possible to reduce
debt of the company and achieve high liquidity (Accenture, 2011). However, companies are in
search of a smooth and effective process through which they can move from theory to practical
implementations off working capital optimization (Aberdeen Group, 2007).
A proactive approach is used by many companies which consider working capital as their
means of doing more with less in any size of organization. Companies after realization of
importance of working capital have started to invest their resources largely in it but if the
working capital management is restructured and streamlined then this heavy investment will also
be unnecessary. Using data as it presents itself and not depending on conventional ways such as
written reports circulated in upper management is one of the hallmarks of working capital
management (Broxton & Mowbray, 2011). Working capital optimization especially in small and
medium enterprises is usually not given much importance to as according to the management the
pursuit of on-going performance is given more importance. Even though management of cash
and running of the cash cycle is a very important part of WCO but in order to excel in this
exercise SMEs should also make payables, receivables and inventory a part of this exercise.
In general this exercise is usually divided in three different parts; cash, receivables and
inventory. Cash is the most important part of working capital. Good and more successful
companies do an in depth analysis of the performance of the company and dig out some very
sensitive areas of the business which in the long run does affect the WCO of the company. These
areas are layoff of unwanted or inefficient employees, regular trainings of the employees and
promotion of multitasking employees, outsourcing reducing the advertisement cost, awareness to

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the customers about the maintained of the product. These are some of the points if focused on the
company can have a smooth and uninterrupted WCO. (Accenture, 2011)
Companies require proper cash management to eliminate the chance of insolvency and
meeting payment schedule. Inventory management is also most important for the working capital
to benefit the organization on the whole. Bhattacharya says that cash from working capital can be
used as investing money. High inventory means high interest and storage cost whereas low
inventory means interruption in schedule of production i.e. underutilization of capacity and thus
low sales (Sagner, 2011). Therefore it is very important to maintain a sufficient level of inventory
for smooth running of sales as well as minimum holding cost of inventory. This can be achieved
with sustaining sufficient stock of raw material, finished goods and minimizing carrying cost of
products. Without inventory a company is just an empty building. Inventory is the most
important part of the company as without it the company cannot bring in money. A firm can
advertise to the maximum, hire the best available employees, make its outlets all over the world
but it cannot function without inventory (Lee, 2003).
The inventory management is the most difficult management department for the company
as excess inventory is bad debt and fewer inventories become a liability. As inventory requires
holding cost, freight, handling costs etc. (Lee, 2003). It is important for the companys future to
equip itself with sufficient stock as per the requirements to full fill the demands. The role of
inventory in WCO is to be available at all times with a directly proportional rate to the demand
of the customer. Stocking inventories companies should also keep in mind the economic trends
of the location as even high demand with a low economic trend of the region can also affect the
ratio of the sales (Mathur, 2007). A successful inventory management cycle is the one in which
the management forecasts the demand trends beforehand. For example if a company sell laptops

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and its outlet is near a university campus then the store keeper should beforehand forecast that
his sales would decrease in the holiday season while boost up in the start of new year. If this
forecasting is done properly the company can save up a lot of money which can be put through a
cycle which benefits the company (Accenture, 2011). Secondly the quality changes or the blunt
change in technology should also a very import factor. A market leader company did not forecast
the change of quality and the technology had to shut down its operations because its inventory
that was once its asset became its biggest liability (Kodak). Just like these inventory policies,
supplier delivery time, waste management are also good points to keep in mind when it comes to
inventory management in WCO (Lee, 2003).
Account receivable is asset which is owed to the firm. When a company gives the buyer a
certain period of time to pay for the purchase then due to this credit sale, funds of company are
blocked and thus result in additional costs. Thus, growth in sales is required to increase profits
(Bhattacharya, 2009). Money is the foundation stone of any company. Without money a
company cant have a future. Money in the company comes in two ways. Either in the shape of
capital which is a onetime investment by the owner and the other is in the shape of sales or
services. The latter is called receivables or account receivables. Most efficient companies have
further categorized the receivables into two categories. One is the inward flow of cash and the
other is the increment of the performance of the company and the cost savings of the company
(Federhen, Behrens, & Springer, 2004).
In the first category of receivables we can plainly understand that the money earned
through the sales is the amount receivables. But in good and efficient companies this is taken a
step ahead. According to them receivables is not only the selling of product. According to them it
is the way of selling of that product in which the sales increase (Hofmann, 2011). As the old

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saying goes a happy customer refers you to twenty more people. In order to make this saying
come alive the good and effective companies put more and more promotions on their product,
they keep in mind that the stock is ever ready. Some good SMES have even taken a step further
in to awareness of the customer about the maintenance of the product by this way they have
cashed the cost of customer service and saved huge amounts of money as well as time
(Accenture, 2011). A company can also improve receivables by making good collection polices
like the introduction of buy now pay later schemes.
The second portion of the receivables is a bit tricky and if a company effectively applies
it then it can make more money and even receive more and more each day. This part of the
account receivables is called the performance of the company. This performance is a very
important part of WCO. If an employee gives is 70% to the company then from it the company
benefit roughly 90%. So if the management could find a way to increase the performance of the
employee the company can cash even more from it. This kind of receivables can only be cashed
if the employees are performing well and for that the company has to give them some incentives.
Secondly a company can also get receivables in the shape of operational savings, for example if
the machinery is give regular maintained checks then it have a long life which means less chance
of breakage (Bhattacharya, 2009).
The last part of WCO is the payables part. Payables are the part when the cash is leaving
the company. Payables or account payables as its commonly known name. It is also one of the
important parts WCO and the most difficult as any company does not want to give away its
money to someone else even though they are using their services. The payables according to
efficient companies have two categories. The first category is the one in which the company has
to pay the money to its suppliers. In this way the company can negotiate the payment terms with

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the suppliers firstly. The company should emphasize on huge discounts as well as longer time
periods in the payment method. The best WCO in the payables method would be to pay less and
keep more stocks. There should be supplier awareness and also the company should have
alternate sources (Broxton & Mowbray, 2011).
The second category of the payables is not exactly in the shape of paying cash but its cost
is too high that effective companies look up to it as a part of payables. This is the operational
costs as well as the ineffective performance of the employees. The cost of ineffective employees
can be saved by layoff or trainings of the employees as an ineffective employee becomes a
liability for the company. This is the kind of cost that the company should be aware of at all
costs. Secondly operational costs should be tried to be kept at a minimum as if the operational
cost increase it is very hard to decrease them (Accenture, 2011).
The key to achieve optimization of working capital is to streamline all the operational
processes like inventory management, supply chain etc. this strategic alignment will allow the
executive-level management to get a holistic view of the companys finances and payables
(Broxton & Mowbray, 2011). Survey (Broxton & Mowbray, 2011) shows that in General Mills,
cooperate controller, treasurer, V.P sales finance, V.P supply chain and shared services director
come together in a monthly meeting to assess cash management, account payables, inventory and
fixed assets. Thus these meetings give the company a proactive approach towards its capital
management resulting in optimized use of companys working capital.
As we know that transportation plays a vital role in inventory management so supply
chain on the whole effects the working capital optimization. A report; Improving Working
Capital Management and Cash Flow Intelligence; by APQC (Broxton & Mowbray, 2011) shows

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that the best practice organizations use centralized financial transaction processes along with the
cross-functional approach to accountability including treasury, sales, supply chain and finance.
Thus to centralize payments and receivables, Supply chain finance (SCF) is one of the most
effective technology. The purpose of this technology is to automate the process of payment
exchange, documents related to payment and information between buyer, seller or other financial
institutions. In order to achieve better results from supply chain finance, companies need to
lower the end-to-end supply chain costs, automate account payable, receivable, purchase order
and invoice deductions. The company requires increasing the visibility of financial aspect of the
supply chain among the trading partners. Supply chain finance should have access to payable,
receivable and inventory financing and invoice presentment and trade document preparation.
When these conditions exist in the company then, supply chain finance can work more
effectively and optimize the working capital for the company (Aberdeen Group, 2007). Ching,
Novazzi & Gerb (2011) also reinforced the supply chain finance that it is very important to
improve inventory efficiency, collection management process, centralizing account payables and
collection process in order to achieve working capital optimization.
Report by Aberdeen group (2007) also shows that supply chain finance technology helps
companies to not only improve financial aspects but also provides innovative business growth
enabling them to grab a greater share in the market. Survey (Aberdeen Group, 2007) shows that
53% companies have automated trade-related document management supply chain finance
processes whereas 40% plan to automate. On the other hand; 19% of the best companies have
automated charge back management (invoice deduction) while 56% are planning to adopt
automated supply chain finance system. 63% implemented electronic invoice and 25% of sample
population showed interest in future implementation. Similarly, 38% currently used electronic

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payment systems while 50% showed planning of future installment of supply chain finance
technology. Every technology has its pros and cons. Similarly, supply chain finance technology
showed five major issues and challenges while implementation. 56% organizations showed
issues regarding internal integration. 55% required to redesign their processes in order for them
to fit in the new solution. In 49% companies, employees showed resistance in the deployment of
SCF technology. Training time and cost was reported to be an issue in 47% of the companies.
Lastly, 44% companies lack of IT resources for the implementation of the system (Aberdeen
Group, 2007).
Management of working capital is different in companies working as fixed capital and
working capital intensive. However, impact of ROS and ROA in working capital group is 21.7%
and 18.4% respectively. Whereas, in fixed capital intensive group, the impact of ROS & ROA are
12.5% and 16.5%. Thus we can say that working capital management is equally important for
both type of groups but the method of management of working capital is different (Ching,
Novazzi, & Gerab, 2011). In order to improve ROS, the variables affecting cash conversion and
days inventory are important to manage efficiently to get optimal results in working capital
intensive group of company. On the other hand, for ROA only days inventory is important.
When days of inventory are decreased, ROA and ROS are improved which shows improvement
in the working capital optimization. There are some standard steps that are to be followed if the
company is trying to improve its performance in working capital optimization from laggard to
industry average or industry average to best in class. Cross functional management Is
critical for the optimization process. Inventory management should be optimized especially if
improving from laggard to industrial average. More sophisticated inventory management
system is required to avoid unstable supply chain.

Also, excess costs from supply chain should

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be reduced. Third-party financing should be used in all types of inventory (Aberdeen Group,
2007).
In order to accelerate cash flow, organizations should have an efficient enterprise
resource planning (ERP) system. It enables the company to take in account the daily credit and
collection activities. When critical decisions are being made enterprise resource planning
provides data instantly and enables the company to decide while taking in account all the factors.
Through enterprise resource planning data can be measured consistently. Companies fail to
optimize working capital because they restrict their forecast of cash flow to the annual reports.
The cash flow should be monitored throughout the year in order to get a more real and accurate
forecast by adjusting the daily cash flow data of the company. The importance of working capital
should be emphasized on all the employees of various functions across the company. It they
understand their impact on working capital, they will improve the current and future patterns of
capital and cash flow (Broxton & Mowbray, 2011). Report by APQC (2011) shows that there are
seven building blocks to measure and manage working capital. These are defined metrics,
timely reporting schedule, accountability of results, cross-functional perspective, summaries for
executives, automated reporting & analysis and benchmarks for process performance (Broxton
& Mowbray, 2011). Applying quality and productivity tools like Six Sigma and Lean speed
improves the financial efforts exponentially. Training finance employees by seminars, courses,
activities, fundamental renewal course and other such activities will focus the attention on
working capital management.
There are many advantages of automated data. One of which is that the problems can be
solved there and then. The buyer can make a more educated decision. Security is also improved
on vendors portal. The ultimate objective achieved through this is that product reaches the shelf

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and sells as quickly as possible and payments are timely.

In

account

payables,

many

techniques are used such as P-cards, third party like bank, EDI feeds, extended payment terms
and twice a month survey to employee payment terms. All this leads up to optimized working
capital. Working capital and cash flow can also be considered as risk management tools. Monthly
review of working capital and cash flow allows timely adjustments on decisions regarding
inventory and supply chain etc. to optimize the working capital (Broxton & Mowbray, 2011).
Broxton also found out through research that it is important for organizations to have electronic
transactions whenever possible and work with and accommodate vendors so that they can return
the favor when time comes. Every firm should value their relationship with the vendors. Thus we
can say that by managing working capital, companies can achieve high performance, aligned
strategic goals with corporate strategies, boast overall profitability and manage systems and data
that support working capital management processes (Broxton & Mowbray, 2011).
Summing it all up, we can say that managing working capital is equally essential for
small and medium enterprises as it are for large organizations. If the company is able to control
the variables affecting working capital then it will be easier to achieve their goal of overall
profitability and success. Inventory and supply chain management play very important role in the
optimization of capital. Technologies such as supply chain finance assist the company to form an
automated system to inventory and supply chain control. This is the era in which zero inventories
are considered more efficient but it depends on the type of service/product. Therefore supply
chain finance provides complete assistance in optimization of working capital through
automating the cash flow system (Bhattacharya, 2009). This allows transparency in the process
and saves processing and holding cost. Errors are caught early due to automated reporting and
analysis of the cash flow system (Lee, 2003). Hence, the automation not only saves time but also

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enables the company to make better decisions. In the ever changing market demand, optimized
working capital and supply chain finance provide the company with the tool to be proactive.
They are in a better position to fulfill the demands of the customers. Supply chain finance
technology takes account of working capital management, order-to-cash and procure-to-pay
processing in any organization.
Having right capital, in right place at the right time is very important for any
organizations overall performance. A report by Royal Bank of Scotland (2011) states that in this
economy and ever changing market, it is very essential to make good use of the automated
working capital solutions provided by various companies. It is more important to generate more
value form existing working capital. Bringing cash and trade together by supply chain financing
is a holistic approach towards the optimization of working capital. In order to fully implement
the working capital optimization management it is essential that all the functional areas of the
company are contributing towards working capital. Training of employee is also required for the
successful execution of the working capital management (Accenture, 2011).
Six Sigma is a problem-solving methodology adopted by various companies in order to
improve their product and service delivery. This process minimizes the chances of error,
lowering costs, increased revenue, improved customer satisfaction and minimal defects and
errors. In order to maximize value by applying Six Sigma technique, rigorous course of action is
followed (Forrest W. Breyfogle, 2003). Six sigma cuts the cost incurred by the company which
do not benefit the customer in any way. In this way, companies are able to reduce capital
spending and helps turn over working capital faster than three or four-sigma companies.
Motorola saved about $15 billion by implementing Six sigma for over 11 years (Soleimannejed,

15
2004). Through Six Sigma, 3-10 % cast can be saved of working capital. It improves the
planning and scheduling of inventory, product phase (in/out) and technology (George, 2010).
Using all the information, it can be concluded that the company needs to align the
strategies and policies with the corporate strategies of the company. A standard process needs to
be placed in an orderly fashion with proper documentation formalities which is understood
throughout the organization. Processes should be implemented which are aligned with the efforts
of optimization of working capital through working capital management. It is very important the
executive level of management shows special concern and interest in optimizing working
capital and also work along the other employees. For optimization of working capital the whole
organization and its every employee needs to understand its importance for the profitability of
the company. Due to supply chain financial and working capital management system, the data
will be real-time. So, the reports presented by management will be based on real matrices and
will provide real time visibility of cash and trade. Employment of optimization techniques will
introduce methods and tools which will enhance the approach towards improvement. It will
create benchmark for the individuals and the company on the whole. Due to this systems will be
introduced which will support the working capital management. So on the whole, the complete
organization needs to work on working capital optimization despite the difference of functional
areas or hierarchy level. Once the business activities are streamlined with the corporate
strategies, the working capital will be optimized in a very effective manner. However, in order to
achieve optimization the organization would be required to go through a complete change to
strategies, methods, policies and procedures. But the end result will be the profitability of
organization for a longer time period.

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