Cash is “Queen”: the importance of working capital

While not negating the importance of long term profit and strategic imperatives, understanding your working capital cycle and how you create liquidity is often overlooked.

To maintain effective and efficient working capital, a company must manage the four key elements of working capital: cash, debtors, creditors and inventory. The latter three items will of course be the focus of understanding both the connection and impact on cash levels.

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The basics

Working capital is the difference between a company’s current assets and current liabilities (current being less than one year generally).

The working capital ratio equals current assets divided by current liabilities. A ratio above one indicates there are sufficient operating assets to meet operating liabilities.

Working capital can be used to measure how efficiently a company is operating. It can also provide an indication of short-term financial stability by identifying whether a company has adequate short-term assets to meet its short-term liabilities.

The working capital cycle is the time taken by a company to convert its current assets and current liabilities into cash. It the company’s ability and efficiency to manage its short-term liquidity position.

User or provider

To ascertain if a working capital cycle is effective, you can assess cycles against whether a business is a 'user' or 'provider' of working capital.

A user of working capital utilises a combined turnaround of inventory and accounts receivable days being lower than accounts payable days. In the example (above) they are effectively using 'someone else's working capital (for 30 days by paying them on slower terms) to support their own working capital needs. This may be achieved by requiring payment on delivery or ordering inventory on time.

A provider of working capital has accounts payable terms less than the turnaround of inventory and accounts receivable days. In this example (refer right) because the business is paying out of cash (creditors) before it receives cash (receivables or inventory), it is effectively a provider of working capital, as it has 30 days where it is unfunded and provides its working capital to others.

Business as usual

Monitoring your working capital cycle regularly is important for the following reasons:

• A negative working capital position indicates that the company’s current liabilities exceed the current assets and is represented by a ratio below 1:1. It indicates that a company has a working capital deficiency and is, or may become, unable to pay its debts as and when they fall due (insolvent).
• A positive working capital ratio indicates a company’s current assets exceed the current liabilities, demonstrating the company can satisfy its short-term liabilities as and when they fall due within the next 12 months. A positive working capital positive is generally viewed as a sign of financial strength and wellbeing.
• Excessive amounts of working capital for a long period of time may indicate the company is not managing its current assets effectively. Likewise, creditor days, which are outside of agreed terms, very low, reducing accounts receivable or diminishing inventory, could be reflective of a business in decline.

A company’s requirement for working capital can vary depending on the following:

• Which industry the company operates in
• The type of products it offers and its key stakeholders
• Differences in collection and payment policies and processes
• Financing arrangements
• Business lifecycle.

Cash is critical for your business operations and monitoring your working capital cycle will assist with strategic planning initiatives.

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Strategic considerations

Understanding your working capital cycles enables you to:

• Prepare and monitor integrated three-way forecast model for planning
• Negotiate existing and required banking facilities
• Map the working capital cycle to identify areas for improvement
• Identify initiatives to improve debtor collection and improve stock turnover
• Identify initiatives to secure more favourable terms with suppliers
• Review internal controls for areas of weaknesses
• Ensure assets are being fully utilised to maximise operating performance.

Why is it critical to understand your working capital position?

• Effective management of working capital is critical to a company’s fundamental financial health and ultimately operational success as a business
• Working capital management can be used to maintain the balance between growth, profitability and liquidity
• Indicates a company’s competency in revenue collection, debt management, inventory management and payments to suppliers.
• A continued negative working capital position is a key indicator that a company may be experiencing financial difficulties or be insolvent
• Businesses must ensure that cash is available to meet their ongoing and future trading requirements. It is possible for a profitable business to run out of cash and subsequently fail.

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How can Cor Cordis assist?

If you require further information or would like a confidential discussion, please contact one of our partners at our office near you.