What is working capital management?
Let’s start off with a definition of working capital management, and then go through some
very practical ideas of managing working capital in real life.
Working capital management: operating efficiently by using working capital to the best effect.
That’s a definition that includes two items that need further definition.
What is working capital, and what does “to the best effect” mean?
There are multiple answers to both of these!
Let me show you!
Working capital tends to get defined in textbooks as the current assets on a company’s balance
sheet minus its current liabilities.
Current assets include items such as cash, marketable securities, accounts receivable,
inventory, and prepaid expenses.
Current liabilities include items such as short-term debt, accounts payable, accrued
liabilities, and deferred revenue.
Yes, that’s a lot of financial terms on one page. Fear not!
There is a much more practical definition, used in everyday business life, that focuses
on those items that are (in real life) often the largest in amount: accounts receivable,
plus inventory, minus accounts payable.
Now that we know what working capital is,
how do we manage working capital to the best effect?
Three options.
Aim to lower working capital to maximize cash flow.
Aim for a higher working capital to maximize profitability.
Or outsource working capital altogether and focus on other strategic areas that require
top management attention.
What are some ways to lower working capital to maximize cash flow?
To measure working capital in an easy to understand way, most companies look at the number of
days rather than absolute amounts, to make working capital a topic that both finance
and operational people understand and influence.
The operating cycle for a lot of product-based companies starts with inventory, measured
as days inventory outstanding (sometimes called days stock available).
For example, a company might have 50 days’ worth of inventory.
Once the product is sold to the customer, a company has open invoices for which payment
has not yet been received, accounts receivable.
The actual length of time it takes for customers to pay is measured as days sales outstanding.
In this example, 60 days.
So this company is financing 50 days worth of inventory and 60 days worth of receivables.
Fortunately, the company does not have to pay its suppliers immediately, and has 40
days payables outstanding.
In summary, the cash conversion cycle (the number of days between cash out and cash in)
is 50 plus 60 minus 40 is 70 days.
This company is financing its working capital for 70 days.
How can it improve?
The first area to look at to improve the cash conversion cycle and reduce working capital
is inventory.
Here are four real life examples of actions a company can take.
Invest in IT systems for parts and inventory tracking.
Eliminate manufacturing bottlenecks for higher throughput.
Hire lean six sigma process optimization / supply chain specialists.
Negotiate consignment inventory from suppliers.
All of these can help to bring the days inventory outstanding down.
The second area to look at to improve the cash conversion cycle and reduce working capital
is receivables.
Four ideas to lower DSO.
Standardize and shorten credit terms to customers.
Improve invoicing accuracy and customer dispute process.
Improve customer due diligence and credit review.
Increase focus on collecting past due receivables.
The third area to look at to improve the cash conversion cycle is payables.
Two main ideas to increase DPO.
Standardize and lengthen terms with suppliers.
Reduce supplier lead times.
The effect of taking various of these actions is that DIO is down from 50 to 40, DSO down
from 60 to 40, and DPO up from 40 to 50.
In total, the cash conversion cycle is reduced by more than half, from 70 days to 30.
This is how companies lower working capital to maximize cash flow.
You could also take working capital in a completely different direction.
Rather than lowering working capital to maximize cash flow, you could actually aim for a higher
working capital in return for more profitability.
This second working capital strategy is an option for companies that have sufficient
cash and want to benefit from a low interest rate environment where it might be relatively
easy to borrow more money at reasonable interest rates.
How to use working capital to increase profitability?
On the accounts receivable side, you could offer your customers longer credit terms in
exchange for higher selling prices.
On the inventory side, you could hold higher stock levels to improve availability, and
then use that higher service level in negotiations with customers to improve margins.
On the accounts payable side, you could offer shorter payment terms to suppliers in return
for higher discounts.
All of these would hurt you in the short term in cash flow, but benefit you on the profitability side.
What if your management attention is focused on other areas of the company (like product
development, and go to market strategy), and you don’t really have the time or desire
to manage working capital?
Well, there’s always the option of outsourcing working capital.
For accounts receivable, this is called factoring: selling your receivables to a bank or financial
institution at a discount.
Your company (bottom left) has an open invoice (accounts receivable) of $100 that your customer
(in the middle) has to pay in 60 days.
They have the cash, and you urgently want the cash, but your customer will not transfer
the cash to you until the invoice is due.
Here’s how a factoring company can help: you sell the open invoice worth $100 to a
bank or financial institution, in return for $99 of cash right now.
The bank then holds that receivable,
and gets paid the full $100 in 60 days when the invoice is due.
Your company gets $99 right now,
and the bank makes $1 for the 60 days it is financing the receivable.
There are various types of factoring, centered around the question of whether or not the
risk of non-payment is transferred as well, but this is the general idea.
Banks also offer inventory financing solutions, in case you need more cash to support operations
and don’t have the resources or possibilities
for significant inventory reduction projects yourself.
Lastly, banks can offer supplier financing.
In a way, this is a mirror image of the factoring of customer receivables
that we just went through.
You (bottom left) have accounts payable to your supplier (in the middle) of $100, which
is the same as saying that your supplier has accounts receivable of $100 on you.
You would like to pay the supplier immediately to take advantage of a cash discount he is
offering for early payment, but you also would like to hang on to your cash
for as long as possible.
In comes the bank again.
They agree a discount deal with the supplier, paying them $99 right now for the invoice
of $100 that is not yet due.
The deal between the bank and yourself is that you can take much longer to pay them
(a stretch in payment terms).
You settle the $100 at the agreed date with the bank.
Working capital management: operating efficiently by using working capital to the best effect.
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