How to Improve Cash Flow in a Manufacturing Business?

Introduction

“Revenue is vanity. Profit is sanity. Cash is king.” As quoted by Pehr G. Gyllenhammar, the former CEO of Volvo, this holds true for all businesses today. A consistent cash flow means a business can pay its short-term debts easily with its available cash while saving reserves for unexpected events. Speaking of manufacturing companies, maintaining a steady cash flow has never been more important, as it helps ensure timely payments to vendors, manage inventory costs and handle receivables.

However, with huge amounts of cash tied up in unsold inventory, wages, credit lines, and production manufacturing businesses face challenges that not only hamper long-term profitability but also adversely affect daily operations. This blog elaborates on the common cash flow challenges faced by manufacturers and discusses strategies to improve cash flow for manufacturing companies.

Understanding Cash Flow For A Manufacturing Company

Cash flow refers to the cash going in and out of a business. For a manufacturing company, cash flow is analyzed using components like cash received from sales, working capital, production and raw material costs, inventory management, equipment and maintenance, procurement and vendor payments, etc.

The manufacturing process goes beyond producing and selling products. A manufacturer has to track costs of production and procurement of raw materials, free the working capital tied to inventory, pay wages to laborers, purchase machinery and equipment, make timely payments to vendors, receive payments against invoices, and much more. The most interesting part of cash flow management in the manufacturing business is the need to settle expenditures before generating revenue while maintaining a healthy working capital.

Additionally, unlike service-oriented companies, manufacturing businesses often face longer cash conversion cycles owing to the tangible nature of their inventory. They often have larger amounts of working capital tied up with excess inventory, leading to cash flow problems. However, when thoughtfully streamlined, a lower cash conversion cycle can be beneficial for the business. This would include timely payments from customers before it settles payments due to vendors. 

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Importance Of Cash Flow For Manufacturing Business

Efficient and accurate cash flow management is the key to a successful manufacturing business. Without steady cash flow, manufacturing companies might find themselves unable to meet debts during downturns. Here’s why maintaining a healthy cash flow is critical for manufacturing businesses: 

How to calculate working capital requirement for a manufacturing company?

For a manufacturing company, working capital includes current assets less current liabilities (excluding mortgage debts and income taxes). The value of assets includes accounts receivable, inventory, raw materials, products in production, and finished goods. In some cases, marketable securities are also considered. 

While calculating working capital for the manufacturing process, it’s crucial to assign a fair price to inventory based on its current market value. However, if any inventory stays on the floor for a prolonged period, then manufacturers must account for possible depreciation or appreciation. 

For calculating liabilities, manufacturers have to include accounts payable and any other amounts yet to be paid to vendors. 

Example of working capital requirement for manufacturing business

Suppose XYZ, a company manufacturing electronic gadgets, has to calculate working capital. Here are the financial figures for the company:

Working capital = $400,000 – $100,000

Working capital = $300,000

This shows that the company has sufficient cash reserves to cover its short-term debts and operational needs, including inventory management for its manufacturing activities. 

Example of Cash Flow Statement For Manufacturing Businesses

A cash flow statement helps a manufacturing company determine their liquidity position and find out how much money is coming in and going out of the business. They can gain insights into the cash available and determine if it is enough to meet financial obligations on time while ensuring a frictionless manufacturing process.

Let’s take the Hershey company’s consolidated cash flow statement for the accounting periods 2023, 2022 and 2021.

Source

The operating cash flow was $2,323,19, and the cash and cash equivalents at the end of the period was $401,902. The company showed positive cash flow results for all three years.

Common Cash Flow Challenges Faced By Manufacturing Companies

Manufacturing companies, being highly capital-intensive, face numerous cash flow challenges. 

• Lack of visibility due to manual cash flow management 

  Tracking cash flows can be challenging if manufacturers still use conventional methods like gathering, arranging, and sorting cash flow data on spreadsheets. This lack of automation not only makes reporting a daunting task but also fails to provide a comprehensive overview of cash. 

  For instance, without automation, manufacturers will have to first log into bank portals to download transaction history, aggregate data, and then consolidate it into spreadsheets for analysis. They will also have to add filters for multiple accounts across regions for different product lines and then reconcile,making cash flow analysis and forecasting a nightmare. 

• The problem of overstocking 

  Manufacturing businesses often struggle with maintaining an optimal inventory level. Either they end up overstocking and tying up working capital, which could have otherwise been used for investing purposes or to meet operational expenses. Or they have inadequate stock and fail to meet customer demand, thereby losing sales opportunities and dealing with declining revenues. 

• Business cycle length issues 

  A business cycle is usually a very tedious and daunting process. It starts with purchasing raw materials, then selling them to customers, and ends with receiving payments from customers and setting aside profits. Receiving cash against invoices takes time, regardless of the billing cycle a business runs. 

  However, with manufacturing businesses, manufacturers have to meet vendor obligations no matter when payments from customers are received. A lack of balance between receiving payments and investing in production activities can make processes difficult. 

• Contingencies or unexpected expenses 

  Manufacturing companies often face numerous unexpected costs like machinery breakdowns, quality control issues, price fluctuations, shortages for raw materials, and supply chain disruption. These expenses not only impact cash flow planning but also make it difficult to clear financial obligations on time. 

• Delayed payments from customers 

  Timely payments from customers are one of the most important elements ensuring smooth cash flow for a manufacturing company. Any delays or discrepancies in receiving payments creates a domino effect, making it harder to settle immediate vendor obligations and manage expenses. 

• Cash blocked in credit 

  When manufacturers offer credit terms to customers but struggle with timely payments to suppliers, it can severely impact the available working capital. Manufacturers need effective account receivable management to alleviate late payments from customers and ensure the timely realization of invoices. 

• Unfavorable production lead times 

  Production lead time refers to the duration between the start of manufacturing processes and receiving revenues from selling finished products. While lead times are essential for production planning and fulfillment, longer lead times without enough margins can put a strain on a manufacturing company’s financial resources, impacting the bottom line. Longer lead times not only tie up working capital in inventory without generating returns but also increase carrying costs like storage, insurance and depreciation expenses. 

How To Improve Cash Flow In A Manufacturing Business?

There is no one-size-fits-all strategy to boost cash flow management for manufacturers. It depends on the nature of the product and the operational challenges a manufacturer faces. 

However, here are a few strategies to improve cash flow in a manufacturing business and enhance liquidity:

• Inventory management
• Reduced lead times
• Invoice factoring
• Automate cash management
• Reassess supply chain
• Rethink pricing 
• Effective AR-AP management

• Inventory management
  Manufacturers tend to maintain a higher level of inventory to meet unexpected surges in customer demand. However, it often leads to overstocking, which further results in tied-up working capital and increasing depreciation cost of unsold inventory. An inventory management system can help manufacturers get accurate inventory data, streamline ordering processes, predict customer demand, optimize warehouse space, and keep stock levels aligned. 

• Reduce lead times 
  Manufacturing businesses often lock in the majority of their cash reserves while purchasing raw materials. This can turn into a major problem if production lead times are slow, as the business will not have enough cash in hand for other critical investments. Manufacturers need to reduce lead times by streamlining inventory production processes, automating manual tasks, and improving internal collaboration for quick movement of inventory. 

• Invoice factoring 
  Delayed payments disrupt cash flows. When customers take too long to pay against invoices, it becomes difficult for manufacturers to tend to immediate operational needs. Invoice factoring here will allow them to sell the outstanding invoices to a third party at a discounted rate in exchange for a cash payment upfront. Factoring a manufacturing business can help manufacturers get funds in a shorter period without waiting for payments from customers, thereby keeping cash flows stable. 

• Automate cash management 
  Manual cash management is not only error-prone and time-consuming. Automating cash management will not only help alleviate mundane, manual tasks but also enable to leverage features like: 

  • Out-of-the-box integration with all major banks to get rapid access to bank statements, parse standard banking formats, and categorize cash into inflows and outflows, mapping into regions and entities. 
  • Bank and cash reconciliation between planned prior-day cash transactions and bank statement items to identify unmatched items in bank statements or cash transactions. 
  • Effective financial instrument management for both fixed and floating rates allows businesses to view interest payments, repayments, and reinvestments, reflecting all related cash flows in the cash position and cash forecast. 
  • Bank account management to manage the bank account lifecycle, log and track signatory details, and maintain the bank document library in one place. 

• Reassess supply chain management 
  Logistics plays a critical role in cash flow management for manufacturing businesses. Manufacturers must reassess these operations and make necessary adjustments, like: 

• Negotiating favorable payment terms with suppliers. Manufacturing companies can convince suppliers for longer payment terms, as it will help hold onto cash longer and enhance profitability. 
• Seeking discounts, early payment incentives, or lower prices for wholesale purchases to leverage savings in the long run. 
• Streamlining internal processes and deploying supply chain technology to enhance efficiency and speed up the process. 

• Rethink pricing
  Pricing can make or break a manufacturer’s revenues. An effective pricing strategy goes beyond market experience. Manufacturers need evidence-based, data-driven decision-making to determine the appropriate price for their inventory. They must leverage real-time data to identify: 
  • Which products give the maximum returns? 
  • Which products have the least returns? 
  • Which products have a lower ROI but lead to customers buying additional items? 
  • Which products give the maximum returns? 
  • Which products have the least returns? 
  • Which products have a lower ROI but lead to customers buying additional items? 

How HighRadius Can Help Improve Cash Flow In Manufacturing Business

Automated, tech-empowered cash flow management is the best way to improve cash flow for manufacturing companies. With this in mind, HighRadius’ Treasury and Risk Suite offers state-of-the-art Cash Management solutions to ensure effective cash flows and timely payment to suppliers while saving enough for uncertainties. 

Manufacturers can leverage features like 100% cash visibility across bank accounts in different regions, banks, or currencies. Tools such as cash positioning and cash reconciliation help build custom templates to analyze cash status and automate reconciliation between planned prior-day cash transactions and bank statement items. Also, manufacturers can also manage Debt / Investment (D/I) instruments with the help of features like auto-populated settlement instructions, interest payments, repayments, and re-investments views. 

In addition, our automated Cash Forecasting solution helps manufacturers forecast payments from customers and anticipate cash outflow to suppliers by leveraging custom-built AI models for AR and AP forecasting. Moreover, they can conduct historical analysis using past data and create scenarios to identify potential adversities. They also perform variance analysis to compare actuals vs. forecasts for better planning and trend analysis based on historical data.

FAQs

1) What is working capital in manufacturing?

Working capital in manufacturing refers to the difference between a company’s current assets and its current liabilities. It is the amount of funds available for day-to-day operations and is essential for a manufacturing company to finance its production activities, manage inventory, and pay bills.

2) What is the optimal working capital for a manufacturing company?

Generally, a manufacturing company should aim for a working capital level that allows it to fund its operations efficiently while maintaining a healthy cash flow position. A well-managed manufacturing company typically aims to maintain a working capital ratio of 1.2 to 2.0.

3) How is working capital calculated for a manufacturing company?

Working capital for a manufacturing company is current assets minus current liabilities. Current assets include cash, inventory, and AR. Current liabilities comprise AP, wages, and other short-term debts. The inventory also considers raw materials, products in production, and finished goods.