Most companies consider profit to be the main indicator of success. It is referred to as the “ bottom line” – the final difference between sales and all expenses, giving the financials an air of finality, as if there is no other number to look at to determine fiscal health!
There is, however another number, that is also an important contributor to profits, and that is working capital (WC) and, more specifically, its turnover, over a defined period. WC is, Inventory plus accounts receivable minus accounts payable, which represent the short-term assets in a business. A company also makes its profits by turning this over efficiently; improve the turn, and you increase your profits.
Despite its significance however, WC is usually not managed actively, or is managed partially.
So how do you manage WC? By managing the individual components that make up the WC, and by understanding their interaction with each other and with the Sales and Purchases of the firm. This interaction and process is also called the cash conversion cycle, the length of time it takes for Cash to be invested in assets and then converted to Sales and then back to cash. Increase the WC turn and you have another increase in profitability in addition to your regular profits. Also, proper management of WC is imperative, as you can otherwise be profitable but illiquid – a situation that can be disastrous as you will be unable to pay your bills or loans.
A company’s goal then should be, to both make money and to have money.
The overall working capital cycle is made up of three separate mini-cycles: inventory, accounts receivable, and accounts payable. In order for working capital to cycle through the business smoothly, these three must be closely monitored. The idea is to track time and dollar amounts, to shorten the cycle for Inventory and accounts receivable and lengthen the cycle for accounts payable. Over-investment in any of these components is called over-trading and is deleterious to the business health. Essentially, managing working capital is like riding a bike- if you stop pedaling, you will fall off.
Here are some ways to improve the management, divided into immediate and planned improvements:
Inventory: this should be further divided into Raw Materials, WIP and FGs
- Can we lower minimum order quantities? If not, can we get extra discounts for large quantities?
- Can we get Inventory on consignment? We only pay for this after we sell.
- Are there any seasonality or close out stocks with suppliers we can make use of?
- Track and shorten time taken from order to accounts arrival: shipping time, customs delay at port, inspection, transfer time, etc.
- How long does it sit before absorbed into production or other use?
- How long does it sit as finished goods?
- How long do finished goods take to ship?
- Utilize forecasting. Generating an accurate Sales/Purchases forecast. Tracking this will give you an idea of how much to order.
- Establish minimum order quantities based on quantity and value – if the value is less you can order more quantity and vice versa.
- Show suppliers how much you bought and look for volume and performance discounts.
- Filter in Warehouse running costs etc.
- Track time in detail between orders and consumption for Inventory in and out.
- Identify the top ten suppliers based on a ranking of importance of all of the above.
- Know your top ten Inventory items DIO
- How are orders received? Can this process be made more efficient?
- How long does it take to fulfill an order?
- Can orders be partially shipped and invoiced?
- Invoice promptly and frequently: Send invoices within 24 hours of a chargeable transaction. Remember, credit terms start from the date of invoice – if there is a delay between shipping and invoicing these are additional days of credit.
- Encourage partial payments.
- Enforce the payment dates.
- Offer incentives for early payments.
- Use technology to speed up the A/R cycle
- InvoicingAccept payments via wire transfers, ACH, and several other methods that drastically speed up the collection and deposit.
- Send it the day the transaction occurs.
- Do it electronically.
- Know your Day’s Sales Outstanding (DSO) in detail – track individual DSO’s for your top ten customers.
- Establish clear credit and invoicing policies
- Establish credit approval and limits.
- This is the opposite of accounts receivable- suppliers accounts payable are really short term investors in your firm!
- Time purchases at month-end, to get additional incentives that maybe available.
- Have you negotiated short or long payment terms?
- What discounts are associated with these?
- Do you have competitive suppliers for your crucial Inventory?
- Can you extend terms, if you buy larger quantities?
- Ensure that the payment cycle is longer than your collection cycle.
- Provide forecast to suppliers. They like predictability.
- Be reliable and keep to payment terms. If you cannot adhere, once or twice, give an early warning.
- Negotiate prices at least twice a year receivable.
- Do a purchase volume/value analysis and know how much you are buying from key suppliers to enable negotiations.
- Watch out for add-on costs. Be careful of being “nickel-and-dimed”!
- Go for the long-term relationship.
- Understand supplier needs – do they want cash quickly ?
- Know your top ten suppliers DPO
While you are doing all of the above, how do you know if you are managing the WC cycle well? How do you track your improvements and know if they are working? To understand this, on a monthly basis analyze the following:-
W Capital days = (Sales/Net Assets) X 365.
This is a composite ratio that also tells you the number of Days of Sales tied up in Current Assets. It is a measure of efficiency; compare it to the past, see if it is increasing/decreasing over time and you will know the efficiency of management.
Cash Conversion Cycle
To understand this in depth, it must be further broken down into three separate ratios- Days Inventory, Days Sales and Days Payable outstanding all of which make up the cash conversion cycle.
Cash conversion cycle = DIO+DSO – DPO
These three ratios are made up as follows:
- Days Inventory Outstanding (DIO) – this shows whether your Inventory levels are over or under your consumption pattern.
(Annual COGS/Inventory) X365
A DIO of over 60 to 90 days is not good, as you are stocking too much.
- Days Sales Outstanding (DSO) – this depicts whether your accounts receivable is over or under compared to your Sales and payment terms.
(Annual Sales/accounts receivable)X365
A DSO of 90 to 120 days is not good. Usual payment time should be 30 to 45 days.
- Days Payable Outstanding (DPO) – this depicts whether your AP is over or under compared to your purchases/Expenses patterns.
(Annual Purchases/AP) X365
A DPO of 15 days means you are paying AP too soon. In this case, a DPO of 60 to 90 days is good as long as you are within payment terms.
As said earlier, profit improvements will be the welcome result of managing this process. Also there are other benefits:-
- Liquidity to pay your bills and loans on time.
- Reassure your stakeholders’ that you are a “going concern”.
- Devote management attention to the future instead of worrying about short term crises in liquidity.
- The ability to expand in a planned assured way.
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