Improving Working Capital Management to Free Up Cash
For companies of all sizes, managing working capital in these uncertain times is easier said than done. But it’s even trickier for smaller companies, making their management of cash on a day-to-day basis more critical than ever.
Business school case studies are littered with examples of management teams failing to pull the levers of working capital — that is, making inventory turns faster, payable terms longer and receivables collections shorter — to the detriment of their companies’ financial sustainability.
Effective working capital management is often considered a proxy for how well a company is run.
Reducing the cash conversion cycle can improve the profitability of a company significantly.
According to Craig Winslow, chief credit officer of GE Capital’s retail lending business, many of the companies that have gone out of business recently “might still be in business today, but they ran out of that precious working capital capacity and had no other means but to file bankruptcy and liquidate rather than run through a restructuring in an organized manner.”
Despite the importance of working capital management — which is often considered a proxy in the investor community for the strength of how well a company is run — mastering the fundamentals of payables, receivables and inventory control poses a challenge for firms of all sizes. Yet the concept itself “is really pretty simple. It’s all about freeing up the company’s cash,” says Patty Weitzman, managing director of GE Antares.
By reducing the cash conversion cycle — a key metric monitoring the length of time between when a firm buys a product from a supplier and the collection of payments from customers for that product — “you can improve the profitability of a company significantly,” reports Rabih Moussawi, director of Wharton Research Data Services.
Moussawi’s research suggests that $1 tied up in net operating capital is worth less ultimately — 52 cents, on average — for shareholders than $1 held in cash that can be invested in growing a business. “A discount of 50% is big,” he says. While knowing the optimal level of working capital is never easy at any company, his research shows “room for improvement.”
At a minimum, firms should rethink old policies to reflect a new operating environment, says Winslow. Having battened down the hatches over the past few years, businesses have significant cash reserves. U.S. and European companies are, in fact, sitting on as much as $2 trillion in cash over and above what they need to operate their companies, reported the May 2011 edition of The McKinsey Quarterly.
“If demand is picking up and macroeconomic factors are going to come back, companies have to be a little bit more inclined to loosen their credit policies for customers and maybe have aggressive investment policies to improve inventories, acquisitions of raw materials and the production process, which require some of this cash in the process,” Winslow notes.
Changing any parts of a working capital machine can have big implications for a company, including its ability to seek funding externally. Winslow recalls one retailer that decided to move its distribution to a large wholesaler from several smaller ones, in the expectation of greater efficiencies and economies of scale. The problem was that the large wholesaler’s policy required that it be paid in five days, rather than the payment terms of 45 to 60 days the retailer had negotiated with the smaller wholesalers.
This kind of scenario can swiftly lead to a negative cycle, Winslow notes. As a company’s available cash is squeezed, its borrowing base also declines if it has an asset-based credit facility. The upshot? The resulting constraints on the company’s borrowing ability may ultimately hamper its growth plans.
What’s more, efforts to improve working capital management can also affect a firm’s customers, suppliers and partners. As many companies learned during the downturn, there’s a limit to how much they can extract from customers by pushing hard on receivables policies and requiring faster payments — jeopardizing their goodwill and, perhaps, future sales. The same is true with payables if a company is too slow to pay suppliers.
Weitzman advises companies to seek out best practices. “Look at other industries as well as your competitors, and be open to feedback,” she says. “We hear clients say, ‘I can’t stretch my payables. I need to pay this vendor today.’ Almost without fail, when push comes to shove and they need to stretch their payables to manage cash flow better, they are able to do that. And their collections department, which maybe they thought was doing a great job, can pick up its game and focus on speeding up receivables by a day, a week or a month.”
After the retrenching of recent years, companies may use the early signs of recovery to “grow too fast, or in the wrong places, and use too much of their precious working capital facilities.” In worse cases, Winslow says there is a disconnect between growth plans and the liquidity to fund those plans, so companies use working capital to, say, do long- term stock repurchases, pay dividends or make acquisitions.
Such investing, he notes, “erodes the ability to fund swings in working capital that are normal just because performance may be off, or something comes up in the industry that needs addressing. When that happens, companies have no other choice but to restructure.”
Winslow would rather see companies being “cautiously optimistic” so that they can continue growing. It will mean striking a fine balance and firms investing to “reinvent themselves” to stay ahead of competition. “They may start adding product lines, or acquiring more inventory,” he says, “but they should be doing it in a very organized, thoughtful way.”