In today's uncertain marketplace, businesses are being forced to re-evaluate their working capital needs. Some managers have learned the hard way during the pandemic that operating "lean" has its limits.
Working capital — current assets minus current liabilities — is traditionally a measure of liquidity. It's the amount of money you need in order to support your short-term business operations. It helps management answer such questions as:
Another way to evaluate liquidity is the working capital ratio: current assets divided by current liabilities. A healthy working capital ratio varies from industry to industry, but it's generally considered to be 1.2 to 2. A ratio below 1.0 typically signals impending liquidity problems.
An alternative perspective on working capital is to compare it to total assets and annual revenue. From this angle, working capital becomes a measure of efficiency.
The amount of working capital your company needs — also known as its working capital requirement — is a function of the costs of your sales cycle, upcoming operational expenses and current repayments of debts. Essentially, you need enough working capital to finance the gap between payments from customers and payments to suppliers. To reduce your company's working capital requirement, you must focus on three key areas: 1) accounts receivable, 2) inventory, and 3) accounts payable. (See "Improving Working Capital Management" at the bottom of the page.)
High liquidity generally equates with low credit risk. But you can have too much of a good thing. Excessive amounts of cash tied up in working capital detract from other spending options, such as expanding to new markets, buying equipment, launching new products and paying down debt. Failure to pursue capital investment opportunities can compromise value over the long run.
The 2022 Working Capital Survey published by consulting firm The Hackett Group reported improvements in the following working capital metrics over the last two years:
As a result of these metrics, the average cash conversion cycle (CCC) improved by roughly 6% in 2021 — from 36.5 days in 2020 to 34.2 days in 2021. The CCC equals DSO plus DIO minus DPO. It gauges how efficiently working capital is managed.
Essentially, the CCC accounts for the timing of converting current assets to cash and paying off current liabilities. A positive CCC indicates the number of days a company must borrow or tie up capital while awaiting payment from customers. A negative CCC represents the number of days a company has received cash from customers before it must pay its suppliers.
Working capital management and liquidity did more than just rebound to pre-pandemic levels in 2021. The survey found that the top 1,000 companies have nearly $1.7 trillion tied up in working capital — up 28% from 2020. Although receivables and inventory are down, cash on hand is up. Reportedly, many large companies hoarded cash during the pandemic.
The survey reported that cash as a percentage of revenue rose sharply to 13% in 2020. In 2021, cash on hand fell to roughly 10% of revenue. The survey reports that many companies are spending their cash reserves to clean up operational performance and pay off debt. But this metric also decreased because companies reported higher revenue in 2021 than 2020.
The survey concluded:
While 2021 ushered in a positive reset for working capital performance, conditions are far from normal — and further improvement is far from guaranteed. High inflation and changing consumer demand patterns will likely drive further inventory buildups as companies take preventative actions to protect margins before passing some of the costs to the end consumer. The accelerating workforce availability crisis is creating significant operational problems for manufacturing, hospitality and retail, as well, putting further economic and supply chain recovery at risk. Rising interest rates will increase the cost of capital, keeping cash flow optimization prominently on the corporate agenda in order to provide liquidity for strategic investments. Geopolitical issues and the conflict in Ukraine continue to reverberate in the market. And finally, the pandemic itself is not quite in the rearview mirror. Diligent focus across all three elements of working capital is prudent in this environment.
Government relief measures — including Paycheck Protection Program loans and temporary tax breaks — injected much-needed cash into the markets, helping businesses stay afloat during the pandemic. Now COVID relief has largely dried up, inflation and interest rates are rising, supply chain issues persist, and banks are tightening their underwriting requirements for commercial and industrial loans. These conditions have brought the issue of working capital management to the forefront.
If you feel working capital analysis is out of your league, consider seeking outside expertise. Your financial advisors can help evaluate working capital accounts, identify strengths and weaknesses, and, ultimately, strike a company-specific balance between liquidity safety nets and cash-flow efficiency.
There's no universal balance between working capital safety nets and cash-flow efficiency that works for all companies. But top performers in any industry closely manage cash flow and seek ways to free cash from working capital. Here are three tips to consider:
1. Speed up collections. The faster a company collects money from customers, the quicker it can capitalize on emerging opportunities or fund a temporary downturn. Possible solutions include tighter credit policies, early bird discounts, collections-based sales compensation and in-house collections personnel. Companies also can evaluate administrative processes — including invoice preparation, dispute resolution and deposits — to eliminate inefficiencies in the collections cycle.
2. Optimize inventory. Supply chain shortages have caused some companies to move from employing "lean" inventory practices to building up safety stock buffers — especially when dealing with offshore vendors. But increasing inventory levels does more than lower cash on hand; it also brings additional costs, including storage, obsolescence, insurance and security. Rather than rely on management's gut instinct, businesses should consider implementing a computerized inventory system (or upgrading an existing one) to optimize inventory management. Today's top-tier systems can more scientifically predict demand, enable data-sharing throughout the supply chain and more quickly reveal variability caused by theft.
It's also important to note that increases in inventory levels might not necessarily relate to having more units on hand. In an inflationary economy, product and raw material prices may bloat inventory balances. Plus, higher labor and energy costs can affect the value of work-in-progress and finished goods inventories for companies that build or manufacturer goods for sale. In other words, the cost per unit may be higher than in prior years.
3. Defer payables. Accounts payable are current liabilities that reduce your working capital balance. You should generally delay paying bills as long as possible — particularly those owed to less strategic suppliers. Unlike current assets, such as receivables or inventory, deferred vendor payments increase cash in hand. But delaying payments to suppliers can backfire if taken to an extreme. For example, deferrals could compromise a company's credit standing or preclude early bird discounts.
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