Improvement Opportunities in Working Capital Management
Working capital management plays an important role in the successful management of a company.
The goal of working capital management is to ensure that the company is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
Along with fixed assets such as plant and equipment, working capital (WC) is considered part of operating capital. Net working capital is calculated as current assets minus current liabilities.
Net Working Capital = Current Assets − Current Liabilities
A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
Current assets and current liabilities include three accounts which are of special importance:
- Accounts Receivable (current asset)
- Inventory (current assets), and
- Accounts Payable (current liability)
By definition, working capital management entails short-term decisions – generally, relating to the next one-year period – which are “reversible”. These decisions will be based on cash flows and/or profitability.
The best measure of cash flow is provided by the Cash Conversion Cycle – the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, the Cash Conversion Cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.
CCC = RCP + ICP – PDP
- RCP – Receivable Conversion Period is the time between the sale of the final product on credit and cash receipts for the accounts receivable.
- ICP – Inventory Conversion Period refers to the length of time between purchase of raw material, production of the goods or service, and the sale of the finished product.
- PDP – Payable Deferral Period is the time between the purchase of raw material on credit and cash payments for the resulting accounts payable.
A positive CCC indicates the number of days a company must borrow or tie up capital while awaiting payment from a customer. A negative result indicates the number of days a company has received cash from sales before it must pay its suppliers.
As industry benchmarks, the lowest value of the CCC is found in the retail, with an average of 35 days, and the highest mean value of the CCC is found in the textile industry, with an average of 165 days.
A company’s CCC indicates its efficiency in managing working capital, and is of particular use in benchmarking versus competitors or comparable companies. Improving CCC is an excellent way to release cash from the balance sheet. Increased free cash flow can be applied to growing the business.
Identify Improvement Opportunities
When looking for improvement opportunities, compile the Cash Conversion Cycle for your company for each of the last five years. How has your CCC changed over the last years? Does it show a decreasing/increasing trend or high variation? Compare your CCC for the most recent year to the industry average.
Even if your company’s CCC shows stability over the years – with a value close to the industry average – it is worth investigating the behavior of its components:
- Compute the Receivable Conversion Period (RCP) for each of the last five years. How has it changed over the years? Does it show a decreasing/increasing trend or high variation? Compare your RCP for the most recent year to the industry average.
- Compute the Inventory Conversion period (ICP) for each of the last five years. How has it changed over the years? Does it show a decreasing/increasing trend or high variation? Compare your ICP for the most recent year to the industry average.
- Compute the Payable Deferral Period (PDP) for each of the last five years. How has it changed over the years? Does it show a decreasing/increasing trend or high variation? Compare your PDP for the most recent year to the industry average.
At the end you can identify improvement opportunities and eventually start a Lean Six Sigma project with following objectives:
- Reducing the RCP – speeding up collections
- Reducing the ICP – processing the raw material as quickly as possible
- Lengthening the PDP – slowing payments
A good example to follow is the Dell Inc. model with a negative Cash Conversion Cycle, which means that their sales are converted in hard cash BEFORE the sale.
Why use your own money when you can use someone else’s for free?