Why Working Capital Is Important
What is Working Capital?
Simply put, working capital is the difference between an organization’s current assets and its current liabilities. Also referred to as net working capital, it is commonly used to measure an organization’s liquidity and short-term financial health.
Assets considered include cash and cash equivalents (e.g., money market accounts), accounts receivable, inventories of raw materials, as well as finished goods and prepaid expenses. Liabilities include accounts payable; accrued wages, taxes and dividends; unearned revenue and debt. By comparing an organization’s assets and liabilities, treasurers can get a better understanding of the organization’s level of liquidity. The formula is:
Working Capital = Current Assets – Current Liabilities
The treasury department can offer insight to the business to help it manage inventory more efficiently. Treasury can also offer advice to help the business understand how procurement and sales decisions affect working capital and influence the bottom line.
Direct actions treasury can take to influence the bottom line include:
1) Influencing DSO: Automate invoicing, simplify customer payments, encourage electronic payments, incentivize early payments, consider tools that extend credit, automate cash application
2) Influencing DIO: Partner internally with business units, utilize internal software and/or ERP systems, establish an internal working group with procurement/purchasing teams, partner with FP&A
3) Influencing DPO: Manage payment terms, improve AP processing, offer funding to suppliers, adopt cost-effective payment methods, implement more efficient payment cycles
Working Capital and Company Viability
Determining an organization’s operational efficiency, or viability, is another product of calculating its working capital. If the working capital is positive, that means the organization has enough to cover any short-term debt. Depending on the amount left over, i.e., residual cash, it may have enough to invest in or expand the business. Now, if the figure is negative, the opposite is true. The organization doesn’t have enough to cover its current liabilities and has low liquidity. Its short-term health, in this case, is poor.
All that said, treasurers need to keep in mind the fact that working capital is not a static figure; it’s always changing. You also have to consider what your assets actually are. For example, if all your assets are in accounts receivable, that’s not a sure thing. What if your client doesn’t pay? What if they file for bankruptcy? By the same token, what if any number of things happen to your inventory, e.g., theft or fire?
Debts aren’t a sure thing either. Agreements can be missed in the middle of a merger. Invoices can be overlooked in a fast-paced environment.
What it boils down to is this: Accurate accounting practices are essential to formulating working capital.
Managing Working Capital
The importance of managing cash and working capital cannot be overstated; without them, organizations simply cannot exist. Yet, when targeting growth, too many organizations focus on trying to increase sales or reduce supplier costs, while ignoring the potential benefits of efficient working capital management.
A renewed focus on internal processes can unlock working capital “trapped” in the cash conversion cycle (CCC) — the time required to convert cash outflows associated with production into cash inflows through the collection of accounts receivable. It is calculated using the following equation:
Cash Conversion Cycle = Days Inventory
Outstanding (DIO) + Days Sales Outstanding
(DSO) – Days Payable Outstanding (DPO)
For help calculating the CCC, download AFP’s Payments Guide to Unlocking the Cash Conversion Cycle.
These funds are then available to be recycled back into the business. Freeing this cash has a direct impact on the business's bottom line. It allows the business to grow because working capital that was previously being used to fund an inefficient process
can now be invested to help the organization achieve its strategic objectives.
How Treasury Can Impact the CCC
Treasury can influence the CCC in two significant ways. First, treasury can introduce, or help with the introduction of, more efficient ways of processing the data and payments associated with the physical supply chain. This is where digitization plays a major part by providing more opportunities for treasury to interrogate data across all three elements: suppliers, inventory and customers.
Second, treasury can help other parts of the organization understand the financial implications of the business decisions they make. Treasury’s influence is growing, which is due in part to a trend toward the centralization of policy setting and
the emergence of technologies that allow treasury to identify and share more detailed insights with the rest of the business. By focusing on the individual elements of the CCC, treasury can help identify potential efficiencies.
Influencing the Bottom Line
Taking action to improve the efficiency of the accounts receivable cycle can result in significant improvements in DSO. Similarly, changing processes within the accounts payable cycle can help the organization improve visibility over its cash and, consequently, manage liquidity and working capital more efficiently.
Treasury cannot directly control inventory in the same way, but the department can offer insight to the wider business to help it manage inventory more efficiently. In the same way, treasury can offer advice to help the business understand how procurement and sales decisions affect working capital and, therefore, influence the bottom line.
Improving Payment Processes and Working Capital Improvements Are the Most Challenging Tasks for Treasury Professionals
Improving payment processes and working capital improvements are the two most challenging tasks facing treasury professionals today, according to the 2022 AFP Strategic Role of Treasury Survey, supported by Marsh McLennan.
All organizations know the importance of managing cash and working capital; without them, organizations simply cannot exist. Yet, when targeting growth, too many organizations focus on trying to increase sales or reduce supplier costs, while ignoring the potential benefits of efficient working capital management.
In a recent webinar, we explored the three keys to treasury optimization, which contributes significantly to a team’s effectiveness as a strategic business partner to its organization, C-suite and board of directors. Here we provide you with some basic tenets of each key, as well as some practical examples of how these keys were implemented.