What is working capital?
Working capital is the money you need for delivering your products or services to a client, before you will receive payment. If you turnover grows, mostly your working capital need will grow as well. If you export to other countries, deliveries and payments mostly take longer, so your working capital need increases even more.
According to the latest Singapore publication of the 2016 American Express CFO Future-Proofing Survey, 38% of respondents cited “tightening cash flow” as the number one challenge faced by businesses. When asked about top business priorities for the next year, “improving cash flow management” again topped the list with 39% of the CFO vote. By far, the most important foundation in improving cash flow is getting working capital under control.
In essence, working capital is the difference between current assets and current liabilities found on the balance sheet of a company. Commonly referred to as the indicator of a company’s short-term financial health, it shows the operating liquidity available to the company. The positive net balance between current assets and current liabilities (there are more current assets than current liabilities) implies that business is generating enough from its operations to pay its current obligations from its current assets.
On the other hand, negative net working capital or working capital deficit (there are more current liabilities than current assets) is an alarming sign indicating the business doesn’t have sufficient funds to pay its maturing short-term debt and cover future operational expenses. Needless to say, achieving positive net working capital with sufficient value is critical for keeping the business running. And once the business has managed to retain desired working capital levels for some time, it should turn to the efficiency of working capital management.
Understanding core components of working capital
In order to implement effective working capital management, the business needs to understand the root causes of tied-up cash. This can be observed by examining cash absorbed during the business operating cycle. A business operating cycle or cash conversion cycle, sometimes referred to as cash-to-cash (C2C), is simply the number of days it takes the company to convert its resources into cash. In other words, measuring the number of days it takes a company to convert the purchase of inventory into sales and collect the payment. Following is the formula for the cash conversion cycle calculation:
C2C = Days inventories outstanding + Days sales outstanding – Days payables outstanding
Days inventories outstanding, DIO = (inventory/ cost of sales) * days in period
Days sales outstanding, DSO = (accounts receivable/ sales) * days in period
Days payables outstanding, DPO = (accounts payable/cost of sales) * days in period
The time lag created by the cash conversion cycle indicates a timing difference between profit and cash flow and results in a working capital requirement of a business. The longer the cycle, the more working capital is needed to fund the time lag and associated costs. Hence, the ultimate target becomes to reduce the time length of the cash conversion cycle and bring down costs to release more cash and reduce pressure on working capital needs.
To do so, business needs to work with each component of the cash conversion cycle – cash, accounts receivable, accounts payable and inventory. Strict management of each and every component of the cash conversion cycle will ultimately lead to working capital improvement and working capital optimisation.
How to approach working capital optimisation
Every strategy starts with the assessment of the current status. A quick overview of a business’ working capital position can be derived from looking at its financial reporting on working capital, identifying baseline working capital metrics and deriving patterns with incoming and outgoing assets and receivables. Good advice for a business would be to benchmark the company’s working capital metrics results to the peers, industry and country.
Then, the business should set long-term objectives for working capital, taking the following into account: development of the business, cash forecasting, funding plans and creating an action plan to achieve so. This can be done by listing the opportunities to free cash flow while analysing weak spots of the current position and gaps in management of working capital elements. Detailed strategies for managing working capital components to improve working capital can be found in the upcoming SME Working Capital Series.
Once the plan is ready, it needs to be completed with accountability and delivery dates for results. Cascading the Working Capital optimisation plan to involve finance, sales, operations, logistics and procurement functions is a must for successful implementation. A good method is to align executive compensation with appropriate performance of working capital objectives. Finally, putting into effect a monthly reporting based on working capital metrics, a monitoring of the quarterly plan execution and an annual review will help the company to progress in improving its working capital long-term objectives.
To summarise, a true strategy towards efficient working capital management is built around the orchestration of all working capital elements – cash, receivables, payables and inventories. Having a long-term plan to achieve working capital objectives will help the company in the short term to fulfil its obligations, add liquidity, reduce the need for additional financing, use released cash to reinvest and increase the company’s value in the long term.
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