Working capital is often under-managed at companies, mainly because its importance isn’t recognized consistently, says Boston Consulting Group Partner and Associate Director Hardik Sheth.
Although a working capital ratio of between 1.2 and 2.0 is typically considered optimal, it’s a mistake to assume a ratio in that range is best for your operations, cash management specialists told CFO Dive.
Working capital differs by operations, but generally it’s the difference between your current assets — cash, accounts receivables and, if you’re a manufacturing company, inventories of raw materials and finished products — and your current liabilities, mainly your accounts payable.
A working capital number that’s on the high side, like 1.7 or 1.8, basically provides you with more breathing room to absorb any large capital expenditures, as well as being a bit more prepared for any sudden episodes, said Sheth.
The onset of Covid-19 is the new classic example of an unexpected event that can make it crucial for you to keep your working capital ratio on the high side, he suggested.
If your ratio is on the low side, say 1.1 or 1.2, you can raise it quickly by holding more income in reserve and delaying vendor and other payments — basically, adjusting your cash conversion cycle (CCC) by making tactical changes to your days sales outstanding (DSO), days payable outstanding (DPO) and, for manufacturers, days of inventory outstanding (DIO).
“How many days is it taking to collect your accounts receivables versus the number of days you are taking to pay your accounts payables?” said Dana Johnson, a Grant Thornton alum who teaches at Michigan Technological University and speaks frequently on working capital at American Institute of CPA (AICPA) events. “What are the average collection and payment days for your industry? If inventory is the issue, is there an issue with obsolescence or is there a lag in demand versus supply? What are typically inventory levels for your industry?”
Hackett Group Associate Principal Craig Bailey said focusing on CCC can be more helpful than looking at the ratio because it keeps your focus on the three key influencers in working capital performance – receivables, inventories, and payables.
“Measuring the CCC allows targets to be set or adjusted and helps a CFO easily identify the areas of risk, and the priority areas of opportunity,” he said. “Generally, the cash conversion cycle will give better insight into a company’s liquidity than the working capital ratio.”
For companies consistently struggling with too much inventory, there are a few quick fixes that are worth considering, said Bailey. First among these: segmenting out inventories by demand behaviors to identify slow-moving inventories that are inflating stock values and are at risk of obsolescence.
Another approach is to create short-term project teams to address problem areas. These might include demand consolidation, customer order/manufacturing batch/supplier lot size adjustment, and make/purchase to order vs. make/purchase to stock strategies, he said.
Boosting the ratio
CCC considerations can also help if your issue is a ratio that’s consistently too high.
If it’s close to 2.0 or above it could be an indication you’re short-changing your medium- and long-term goals, said Sheth.
“One should promote the use of assets toward R&D, capital projects and other investment areas,” he said.
For companies with inventory to manage, your DIO can tell you if you’re holding inventory longer than is optimal before converting to sales, he said.
There could be several factors causing this, he added, including poor sales performance (unable to convert leads into orders) and not regulating production levels appropriately, among other environmental or business condition factors.
Looking at the technology for assessing working capital, Sheth said it has evolved well and the requirements for making it work effectively aren’t as onerous as they once were.
Like with so much of tech, though, the idea of garbage-in, garbage-out applies, so failure to review the information and data generated from the system in a timely manner can leave you making decisions based on bad data, said Johnson.
“Key metrics should be reviewed on a monthly basis to include liquidity and activity ratios. Inventory turnover, average days of AR collections, average days of paying AP, etc.,” she said.
At the same time, she said, tech and working capital is a gray area with no one-size-fits-all solution.