Working Capital Management is the measure of Current Liabilities compared to current Assets and is a measure of the ability of a company to meet its short term needs with cash. Cashflow is a measure of the cash coming in and leaving a company.
What it is: Working capital is the money necessary to manage your inventories and account receivables and can become very expensive in a growing business. Most growing businesses must find financing to grow the inventories and accounts receivables necessary to support their growing revenues. Working capital is calculated by adding the value of inventories (raw material, work in process, finished goods) with Accounts Receivable and subtracting Accounts Payables and NIBLs (non-interest-bearing liabilities). Cashflow is the total value of all cash inflows minus the total value of all cash outflows in a company. Cashflow is different than profit (net earnings) and indicates the availability of cash to the business or the need for financing operations. EBITDA (earnings before interest, taxes, depreciation, and amortization) is a quick surrogate often used to estimate cash flow.
What does it do: A company runs on cash, and the supply chain elements of the company can tie up large quantities of cash. By managing the supply chain, logistics, warehouse and inventory management, accounts receivables, and accounts payable a company can make wide swings in working capital and cash flow. Poor management of working capital and cashflow can limit the ability of a company to grow.
Uses:
How is it used: Cash is necessary to run a business. Managing cash flow to make sure that cash is available as needed to run the business is a necessary activity. Working capital is one of the primary sources that tie up cash and keeps it from being available to run the business or pay the stockholders. Successful management of cash flow and working capital are the hallmark of excellent company leaders.
Where: While cash flow and working capital can be impacted by many operations of a company, it is in the supply chain where there are the most levers. Examples include:
Inventory management:
Maintaining high finished goods inventories may help keep customers happy, but it can have a very negative impact on cash flow and working capital
Increasing the number of unique products (SKUs) increases the number of products that must be inventoried. You may be able to have 10 units of a product inventoried if there is only one unique version, but you may need 5 inventoried units for each of 10 unique products, and therefore a total of 50 inventoried items instead of 10. This significantly increases working capital.
Manufacturing operations need a constant flow of raw materials, but maintaining large safety stocks is expensive and ties up large working capital costs. Many manufacturing facilities have implemented "Just in Time" shipping arrangements with their suppliers to limit on-hand inventories. You can also ask for vendor-managed inventories (or consignment inventories) where the products are stored on your site, but you are not charged for the raw materials until you use them.
Terminalization is a process for moving inventory closer to the customer but may increase the amount of inventory necessary to be maintained in the system.
Accounts receivable (A/R) can tie up large quantities of cash. The problem of A/R can be exacerbated by having extended payment terms. Many companies use a Net 30 payment term that says the customer will pay 30 days after invoicing but in some Asian markets, the standard is net 90 days. Others use terms like 2% 10 days, Net 30. This term will give a 2% discount if the payment is received within 10 days, but the entire invoiced about is due if paid within 30 days. There are other systems designed to minimize the length of A/R, like selling your A/Rs to a bank at a discounted rate to get a reduced amount of cash immediately.
Accounts payable is also a large cash outflow, and if you can extend the length of time that you have in which to make the payment you can increase "float" which reduces working capital and the timing of cash flow.
Why: Because cash is the lifeblood of a company, the management of working capital and cashflow can be essential to the health of the company.
Limitations:
Where it shouldn't be used: There are no places where you can ignore the impact of working capital and cash flow, but see the warning below.
Any restrictions: none
Warnings: Making decisions that improve working capital but shuts down the manufacturing facilities for lack of raw materials, or limits our ability to supply products when our customers need them, can be counterproductive to the profits of the company.
Gathering data: Identify all the sources of current assets and current liabilities in the company and all the sources of incoming and outgoing cash.
Identify all sources of current assets and liabilities being managed by the company including:
Raw material inventories
Work in process inventories
Finished goods inventories
Finished goods in off-site terminals and 3rd party warehouses
Accounts receivables and the terms negotiated and the level to which payments are timely
Accounts payable and the timing with which they are being met
All sources of available cash
All NIBLs (non-interest-bearing liabilities) that will need to be paid (e. g. unpaid employees salaries and taxes to be withheld)
Analysis of data: Completing some basic ratios can help us gain some insight into our current situation:
Working capital ratio: Is the ratio of current assets divided by current liabilities (ie. Inventories and A/R divided by A/P and NIBLs)
Collection ratio: This is calculated by multiply the average amount of accounts receivable per day times the days in the accounting period (e.g. a month) divided by the total net credit sales during the month.
Inventory turnover: Inventory turnover is calculated by dividing revenues by the cost of inventory. This is often done as an annual revenue number to see how many turns of inventory are seen per year.
Interpretation of results: Each ratio should give you an indication of the health of your working capital management
Working capital ratios of below 1 indicate that there is not enough cash to pay current liabilities. Ratios from 1.2 to 2 are considered healthy. Ratios over 2 indicate that assets may not be appropriately applied to grow and manage the business
Collection ratio: The collection ratio calculation provides the average number of days it takes a company to receive payment, in other words, to convert sales into cash. The lower a company's collection ratio, the more efficient its cash flow.
Inventory Turnover Ratio: the ratio can vary greatly by industry. It is best to compare your ratios to your competitors in the industry to see how you are doing. A ratio that is lower than the industry indicates that you are not efficient in managing your inventory levels compared to your sales. An inventory turn ratio that is much higher can indicate that you do not have adequate inventory to meet your customer's needs.
Presentation of results: Your presentation should show the data used to create the ratios, how your ratios compare with others in your industry and what recommendations you make for improvement for your working capital and cash flow management.
Your presentation should show the data used to create the ratios, how your ratios compare with others in your industry, and what recommendations you make for improvement for your working capital and cash flow management.
