The Impact of Rising Interest Rates on Working Capital

The significant increase in interest rates over the past year has universally impacted the economy, without a doubt. The cost of external financing, in particular, has hit companies exponentially. Because of this, most businesses are trying to effectively manage its cash flows from operations to minimize its need for high-interest rate borrowings. To achieve this objective, companies’ primary focus has been to improve its working capital management by accelerating the average time it takes to convert working capital to cash, otherwise known as a cash conversion cycle.

For companies in the manufacturing and distribution industries, inventory is normally a significant working capital element. The opportunities and, let’s face it, the probability to control and minimize the business’s on-hand inventory quantity may be an easier route for management to influence the company’s cash flows from operations. Compared to other options, like accelerating the collection of accounts receivables, extending the vendor credit terms or delaying payments to vendors, without potential negative consequences could be a more complicated approach.

To effectively manage working capital, leaders need to periodically monitor related ratios and key performance indicators, including the business’s inventory turnover ratio, to identify opportunities to reduce the average on-hand quantities of inventories.

How To Effectively Manage Working Capital

To do this, business leaders should gather relevant data to analyze the gross margins earned by each of the company’s products. This will identify slow moving and obsolete products and enable companies to make appropriate revisions to its purchasing policies and procedures. This oftentimes includes the decision to discontinue products that generate less than average gross margin.

At this point, a manufacturing or distribution leader needs to consider if reducing the base stock levels and minimum order quantities are viable options. Explore avenues to reduce lead time, including alternative vendors, changing order frequency, and centralizing or decentralizing purchases, as considered appropriate for the business.

Leveraging Six Sigma methodologies, including Kanban and Kaizen, to address these options can be very helpful in these times. With Kanban, each inventory item is assigned a visual indicator with set reorder points, helping to ensure that the items are restocked just in time to avoid excess inventory.

Kaizen promotes a culture of continuous improvement, and through regular Kaizen events, improvements to the inventory management process can be made iteratively to optimize order quantities, reduce lead times and streamline workflows.

Reducing the cash necessary to fund the company’s working capital by limiting the purchases of on-hand inventories can improve the cash flows from operations and reduce the need to borrow against high-interest external financing.

Further, the company’s accounting systems and various technology tools, including AI, should be scrutinized to see if they could be better utilized to enhance the company’s inventory management process.

Reduce Working Capital

According to S&P Global Market Intelligence, a financial data firm, more than 200 companies in the S&P 500 that reported 2023 third-quarter results indicated inventory values increased by approximately 15% compared to the third quarter in the prior year. Additionally, the average days of inventory outstanding increased from 78 to 85 days over the same period, per S&P. This indicates those companies are potentially carrying higher than average on-hand inventories. For companies in similar situations, effective inventory management might be the best option to reduce its working capital needs.

Improve Cash Conversion Cycles

Accelerating the billing and collection process is another approach to improving a company’s cash conversion cycle. Increasing financing costs could force some companies to delay payments, and in turn, would increase the risk of bad debts. Therefore, it’s critical for management to analyze its options to incentivize customers to make payments more quickly, such as by providing cash discounts and early payment discounts. Business leaders can also consider comparing the cost and benefits of changing the company’s credit policies vis a vis its average cost of borrowings. Accelerating the collection of accounts receivable may also minimize the risk of bad debts.

To learn more about the services we offer at Sikich for manufacturing and distribution companies, please get in touch with our audit and digital transformation experts.