What is Working Capital?

Many students are only familiar with the textbook definition of Working Capital but are not as familiar with what it actually means for real-life businesses or how to think about this concept on the CFE. Given the important of this topic, we have asked one of our regular contributors, Alla Volodina, to discuss the topic.

Working Capital Management – releasing the hidden “cash cow” on your balance sheet

Warren Buffett famously said: “Cash … is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent” (Warren Buffett: 3 Ways to Protect Your Savings From a Crisis). Hiring a new team, securing suppliers, obtaining financing, getting the next client and marketing a new product are among the many things on the minds of entrepreneurs starting or growing their small businesses. However, working capital management, which everyone agrees is an important topic in theory, gets pushed to the sidelines in practice. Its results are at times are slower to materialize and the work can seem less engaging than making a pitch to a potential client. And yet, working capital management is sometimes the answer to the question that every entrepreneur asks going to sleep at night – how will my company not just survive but thrive?

What is working capital management?

Working capital management is the management of short-term assets and short-term liabilities. It refers to how efficiently the funds provided by debt and equity holders are used in the organization in the short-term. Working capital management focuses on the cash conversion cycle (CCC) which is a measure of efficiency in managing cash or how long cash is tied up in working capital. The longer it takes your company to convert cash into sales, the higher the chances that you will need additional financing to grow your operations. Obtaining additional financing is costly – dilution of ownership or additional interest expenses (regardless of how small or large) – especially when considering that you could instead release a hidden “cash cow.”

I want to manage working capital, but how?

To start managing your working capital, you need to ask such important questions as: Is my company piling up inventory in the warehouse months before it’s sold? How quickly are customers paying us? Do we have a systematic way of paying our suppliers? Are we taking advantage of all the favourable terms offered by our suppliers and have we tried negotiating more favourable terms with them? Have we built sufficient customer loyalty to convince customers to pre-pay for our products?

One thousand large U.S. companies saved $72 billion in working capital in a given year by enhancing how they collect bills from customers, pay suppliers, and manage inventory, according to survey results from Atlanta-based consulting firm Hackett-REL (Top U.S. companies find benefit in reducing working capital, Dec 2006). In fact, improving working capital is an explicit focus of many large organizations. For instance, Pepsi told investors on its earnings call that it improved its working capital cash conversion cycle by more than 30 days, which contributed $2.5 billion to cash flow improvement (PepsiCo (PEP) Indra K. Nooyi on Q4 2015 Results – Earnings Call Transcript). On the other hand, Pepsi’s direct competitor, Coke, told investors that they have improved their cash conversion cycle as well which resulted in $600 million incremental cash flow for the first nine months of 2015. Next time your shareholders ask you about your cash conversion cycle, would you be able to give them similar positive news?

Improving cash conversion cycle is not just an exercise to be delegated to an accounting department. It is a company-wide exercise that requires in-depth strategic analysis. Certainly, if your cash conversion cycle is shortened by a day or two, it is indeed a good result. However, how would that result compare to a negative cash conversion cycle (that is, having cash from customers available for when you need to pay your suppliers). Some companies possess enough leverage with their customers to be able to achieve just that – a negative cash conversion cycle. As of September 26, 2015, Apple’s cash conversion cycle is an amazing – 60 days (Stock Analysis on Net – 100 U.S. Stock Market Leaders; Stock Analysis on Net – 100 U.S. Stock Market Leaders).

How do I measure whether my working capital is being managed effectively?

Many measures allow you to determine if you are managing working capital effectively. For example, the receivables turnover ratio will indicate how many times accounts receivable are created and collected during a fiscal period. Similarly, inventory turnover ratio will show how often inventory is created and sold during a fiscal period. Both of these measures can also be presented in the number of days. Compare a company that converts its accounts receivable into cash every 55 days, versus a company in a similar business that converts every 70 days. This means that, unlike the former company, the latter company needs to have more financing available to continue operating for additional 15 days.

Another useful measure is “days working capital”, which indicates how many days it will take for a company to convert its working capital into revenue. Depending on your line of business, you can improve (or lower) this ratio by managing one or more of the working capital elements mentioned above. For instance, if inventory is shipped from abroad then managing inventory turnover will prove to be more difficult than managing your accounts receivable turnover.

Cash conversion cycle is calculated by taking days “days AR outstanding,” plus “days inventory” (which measures the inventory turnover ratio) subtracting and “days accounts payable.”

If you have any questions for Alla Volodina or other contributors, please email us at info@examentor.ca