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Working Capital Series: Optimizing Profitability (Pt.2)

Topics: Finance, Management

A recent study on the working capital practices of the manufacturing and distribution industry confirmed that 32% of executives deem optimizing working capital as “extremely important”. Another 50% rated it as “very important.” An amazing 88% believe working capital management can boost profit margin.

This is part two in a series designed to help you turn working capital into an asset that can boost profit margin. In part one, we defined working capital and the steps you can take to get out of a working capital financing gap. In part two, we’ll focus on working capital optimization. It is the process of optimizing working capital that makes it profitable. By adopting best practices around working capital management, CFOs can optimize working capital and improve profitability.

Profitability and Working Capital Management

Cash flow is such an important aspect of profitability and efficient operations that businesses often bring in consultants to help implement quality programs aimed at process improvement and the elimination of redundant processes. Still, cash flow isn’t rocket science. You don’t need an MBA to figure it out. All you need is the right toolset. Like a superior lens, the right tools can change the way you perceive an issue. Indeed, without the right toolset what you perceive as a hole in the ground may actually be a pot of gold.

The right tools can bring clarity, focus, dimension and light to something that seemed deadly before. Suddenly quicksand becomes paydirt and your monthly credit crisis becomes an opportunity. The result is a cleaner depiction of the company’s true cash position due to improved inventory management, improved debt management, better revenue collection, and renegotiated payment terms with suppliers. These are all functions directly attributable to working capital management and each one has a direct impact on profit.

The Working Capital Opportunity

The ability to reduce accounts receivable days and extend payable days without incurring fees or interest is the key to making money from working capital. The combination frees up cash and provides you with multiple lines of free short-term credit, which reduces net interest expense, and results in a direct increase to profitability. It may also turn into a source of short-term financing to fund marketing, research, new product introductions and other opportunities to drive sales. It will also have a halo effect on inventory management, debt management, revenue collection and your relationship with suppliers. For example, improvements in inventory management may also improve managerial confidence in inventory. As a result, the supply manager has no need to order surplus inventory, which is an inefficient use of working capital. Improved inventory management also mitigates the risk of write-offs through inventory obsolesce.

Working capital gives analysts insight into the cash flow health of a company, however, it can sometimes give a false signal. Positive working capital is good, but not if it’s due to high receivables or inventory. For this reason, savvy CFOs use the cash conversion cycle (CCC)  to profit from changes in working capital.

Working Capital Optimization Strategies

A positive working capital is desirable, however, a high working capital isn’t always a good thing. Too much inventory on hand is a sign of inefficiency. Likewise, accounts receivable must still be collected and represents an interest free loan to your customers. Both are necessary for business, and both increase your working capital, but the optimal business model involves just-in-time inventory and no accounts receivable. It also includes maximizing your supplier’s free credit as much as possible.

The CCC is the amount of days it takes for a company to convert working assets into cash flow. A short cycle means working capital spends less time tied up in business processes, which improves the bottom line. In other words, it measures the amount of days it takes to sell inventory, collect receivables and pay bills. It is calculated by adding days inventory outstanding (DIO) to days sales outstanding (DSO) and subtracting days payable outstanding (DPO). A smaller DIO and DSO are preferred. By maximizing DPO, the company holds cash longer, therefore, a longer DPO is preferred.

Now that you know how to measure improvements in short-term cash flow with the CCC, you can use the measurement to gauge the effectiveness of strategies used to help reduce the operating cash cycle and extend the payables cash cycle.

There are three main things a company can do to bring working capital into positive status:

  • Negotiate longer terms with suppliers.
  • Liquidate or reduce accounts receivable.
  • Liquidate or reduce inventory.

Renegotiating for longer credit terms is easier if you have more power that your suppliers. The power of suppliers, however, generally depends on the industry. If you don’t have much power over supplier relationships, the second best thing to do is liquidate or reduce accounts receivable. This can be accomplished through the development of a tighter credit policy to reduce collection times, but a tighter credit policy will negatively impact sales so this is an option of last resort. Your best option is to find a toolset that can help bring clarity to your accounts receivable situation. The toolset should provide a way to incorporate the speedy liquidation of accounts receivable as a normal business process. By focusing on the extension of accounts payable and the liquidation of accounts receivable, businesses can turn working capital into a profit center.

In Summary

This is the end of a two part series on growing and profiting from working capital. We know that working capital shortages are a primary cause of business failure. We also know that business failure can happen even as sales and profits are growing on the income statement. Still, according to a recent survey, only 54% of companies have implemented a working capital strategy. One strategy is to sell or liquidate accounts receivable. Another is to apply for a line of credit. Combined with the extension of payables, this simple strategy gives companies the ability to decrease net interest expense and increase profitability.

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