Seeing the Light (on Working Capital)

Posted by on Jan 21, 2014 in Academic Research, Drivers of Cash Flow, Working Capital

The truth is in the cash flow

Seeing the Light (on Working Capital)

When I was in my teens, a favourite movies was the Blues Brothers. It was shown at the (then) decrepit Cremorne Orpheum cinema in Sydney. We’d watch, dance and sing along to this movie with its absurd plot, revelling in its wonderful sound track.

If you are familiar with the movie, you will know that Jake and Elwood are on a mission from god, to raise the money needed to save the orphanage where they grew up. They don’t know how they are going to source the money until Jake “sees the light” and they decide to put the band back together.

This blog will help SME owners “see the light” on why managing working capital is an easy way to increase cash flow. It picks up on a key message from the research set out in my first blog (It’s Not Rocket Science, 19 November 2013) being that a business with a shorter cash conversion cycle (ie: one that manages its working capital) has better liquidity, requires lower levels of capital and enjoys better returns on investment than a firm that does not manage its working capital. It will give the SME owner the tools needed to begin managing working capital.

First, let’s define a few key terms.

The Cash Conversion Cycle is the number of days between the outlay of cash (to acquire inventory, for example) and the recovery of that cash (the collection of sale proceeds from debtors). It is calculated by adding Debtor Days to Inventory Days and then deducting Creditor Days from this figure.

Debtor Days is a measure of the number of days it takes to collect debtors. It is calculated by dividing Trade Debtors at a point in time by the aggregate of Sales for the 12 months to that point in time and multiplying that result by 365.

Inventory Days is a measure of the number of days a business holds its stock before it is sold. It is calculated by dividing Stock at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

Creditor Days is a measure of the number of days it takes a business to pay its trade creditors. It is calculated by dividing Trade Creditors at a point in time by the aggregate of Cost of Goods Sold for the 12 months to that point in time and multiplying that result by 365.

The Capital of a business is the sum of the equity provided by the owners of a business plus the debt a business has raised from its financiers.

The Working Capital of a business is the amount of Capital invested in the Net Working Assets of the business.

The Net Working Assets of a business are its Inventory plus Trade Debtors less Trade Creditors.

To manage Working Capital an SME owner first needs to measure and track the value of the Net Working Assets and Cash Conversion Cycle.

Net Working Assets represent a Point in Time view of Working Capital. An SME owner who tracks the value of their Net Working Assets on a monthly basis will know the amount of Capital invested as Working Capital and whether that investment is rising (using cash) or falling (generating cash). By breaking the Net Working Assets into its constituent parts, the SME owner can establish the driver(s) for the movement in their Working Capital.

The Cash Conversion Cycle is a Relative view of Working Capital, which provides the SME owner with information about how their Net Working Assets are moving relative to the trading of the business. By tracking the Cash Conversion Cycle over time a business owner will receive information about how efficiently their business is using its available Capital – a falling Cash Conversion Cycle is a sign that capital use is becoming more efficient (ie: you’re stretching a dollar of capital further), a rising Cash Conversion Cycle is a sign that capital use is becoming less efficient (ie: you’re likely to run out of capital sooner).

This information is useful to all SME owners, in all business situations. It is essential for an SME owner with a growing business as nothing uses Capital quicker than growth.

Working Capital management begins when an SME owner uses the information from tracking Net Working Assets and Cash Conversion Cycle to identify and prioritise for review those operational elements of their business that impact on Net Working Assets. For example, the invoicing process, customer credit policy, and debtor collection process have an impact on the value of Debtors and on the Debtor Days ratio – by reviewing these processes it may be possible to reduce the value of debtors / speed up their collection without compromising Sales. Similarly, stock re-order triggers, minimum and maximum holdings, identifying fast and slow-moving stock, and supplier delivery times have an impact on the value of Stock and the Stock Days ratio – by reviewing these processes it may be possible to reduce the investment in stock / reduce its holding period without compromising Sales.

Process improvement can be measured by tracking subsequent changes to Net Working Assets and Cash Conversion Cycle. Using this approach, continuous improvement and low risk, incremental changes to working capital related process is possible. If done successfully, the SME owner will see a permanent reduction in the use of their Overdraft, or a permanent increase of funds in their Bank account.

The SME owner who has “seen the light” has options in the form of access to greater cash flow: they can use this cash flow to invest in the continued growth of their business, to pay a dividend, or increase the efficiency of their business. If you’re not already actively managing your working capital it is time to jump on the band wagon.