Working Capital Management Optimisation
Working Capital is the net short-term assets of a company which are made up of:
- current assets (cash and quickly realisable assets including short-term and marketable securities, inventory and accounts receivables)
LESS
- current liabilities (which are repayable normally within one year, e.g. accounts payable, short-term loans, issued commercial paper and other short term debt, repayment obligations on long-term debt, and other short term liabilities).
Operating Liquidity
Basically, working capital is the operating liquidity required for the company to operate. It is the number of Days Sales Outstanding (DSO) plus the Days Inventory Outstanding (DIO) less the Days Payables Outstanding (DPO). For example, if the DSO is 35 days, DIO is 45 days and DPO is 15 days, the total cash days is 65 (35 + 45 -15 days). Therefore if sales are $5bn a year, daily sales are $13.7m, the total cash required to run the business is 65 x $13.7m = $890m.
Working Capital Management Progress
The need for improved working capital management (WCM) is growing as tighter credit markets continue resulting in significantly higher borrowing costs. Releasing working capital is, for many companies, the cheapest and readiest source of finance. Generally, working capital management efficiency does appear to be improving. REL Consultant found that in 2010, although there was still some €724bn excess working capital tied up in the top 1,000 firms, head quartered in Europe, Days Working Capital (DWC) is now at an all-time low of 42.9 days. This represents a 7.6% improvement compared to 2009, but it is not close to the USA's 35.8 DWC.
Cash Conversion Cycle
The overall WCM efficiency of a company is shown by the net number of days in their Cash-Conversion Cycle (CCC) from the outlay of cash for raw materials to receiving payment from the customer.
The shorter the CCC, the less money is tied up in working capital. Optimising the Cash Conversion Cycle is the key to unlocking working capital in any business and focuses on three areas:
- Procure-to-Pay (P2P) cycle where the main objective is to maximise the average number of days taken to pay creditors (Days Payables Outstanding - DPO)
- Order-To-Cash (O2C) cycle where the main objective is to minimise the average number of days taken by a company to collect payments after the sale is completed (Days Sales Outstanding - DSO)
- Inventory Cycle management where the main objective is to accelerate the inventory turnover, i.e. minimise the number of days taken to convert inventory into sales (Days Of Inventory - DOI).
Days Working Capital
Another way of analysing overall company working capital performance is to describe how many days it will take for a company to convert its working capital into revenue. The faster a company does this, the better.
To calculate days working capital, use the following formula:
Average Working Capital x 365
Annual Sales Revenue