People engage in business deals with working capital on a daily basis.
By definition, working capital is the difference between the current assets and the current liabilities. For those who are familiar with financial statements, working capital consists mainly of cash, the value of the inventories and account receivables, less accounts payable. It is, therefore, a company’s net investment to support its day-to-day operations, and the amount needed varies from industry to industry.
Working capital is often called the revolving or short-term capital. There are three types of working capital:
Gross and net working capital—The gross is the companies’ total current assets while the net working capital is the difference between the current assets and current liabilities.
Permanent working capital—This is the minimum amount of working capital that must always remain invested. These are the assets necessary for a company to carry out its day-to-day operations. In all cases, some amount of cash, inventories or trade receivables are locked in.
Variable working capital—Working capital requirements of companies might increase or decrease from time to time due to various external and internal factors, including seasonality of the business. Variable funds, therefore, are drawn from short-term sources.
Now, why do we need to understand and know the importance of working capital management?
Working capital management is about managing current assets and current liabilities. This involves managing the relationship of the company’s short-term assets with its short-term liabilities. Managing working capital is essential to ensuring a balance between liquidity and profitability.
In order to achieve this balance, the company needs to adopt certain management strategies and policies, such as:
Cash management—One of the essential tools that can be used to effectively manage cash is the statement of cash flows and a daily cash position report. A company should determine the correct amount of cash it needs to fund its daily operations while minimizing cash holding cost. It is also important to maintain a pre-determined reserve fund or standby-credit arrangement, which can be used in case there is a shortfall in cash inflows or for a new opportunity that unexpectedly comes up requiring quick cash deployment.
Inventory management—It is also essential to determine the level of inventory to support sales and marketing efforts, and optimize re-order points, avoid stock-outs, and m inimize warehousing costs.
Trade receivables/Credit management—Identifying the appropriate credit terms, discounts and efficient billing and collection systems is vital. The expression ‘Cash is King’ may be a cliché but it is so true. For many businesses, cash is the lifeblood, and tying up working capital in receivables could lead to cash flow deficiencies and an inability to meet currently maturing obligations.
Financial and financing management—This involves an overall financial health check and identifying the sources of financing or funding to support business operations. Use of supplier credits, banks loans, factoring of receivables, pledging of inventories, and borrowing from other financial institutions or even infusion of capital from shareholders should all be considered.
If working capital management is an essential part of running the business, why do some companies fail in managing and optimizing their working capital?
In a report entitled “Making working capital work,” Deloitte identified some internal challenges to optimizing working capital to increase shareholder value.
Challenges to working capital optimization
Limited access to needed information:
One challenge is that many companies lack the real-time data and metrics needed to evaluate the effectiveness of working capital and improvements.
Lack of a formal structure for working capital improvement efforts:
The research also pointed out that whether improving working capital is a cross-functional effort or is driven by finance, it can be difficult to sustain the effort without a formal structure.
The number of working capital stakeholders and their differing perspectives:
The distributed nature of working capital, in which one stakeholder within finance may own accounts payable and another accounts receivable, can make it difficult to implement a working capital improvement program. Each stakeholder is likely to have a different perspective on how to enhance working capital, and their views could also differ from those who are running operations.
Organizations often struggle to focus on optimizing working capital because of other priorities competing for attention. A discussion on managing and optimizing working capital may be sidelined due to other priorities that the stakeholder may deem more important.
In the same report, Deloitte provided some steps that companies can take to implement and support a sustainable working capital optimization program.
Mandate and communicate—Deloitte recommends that an effective working capital optimization program should start with a tone-at-the-top mandate from the Board, the CEO, and the CFO. Senior management should make clear that improving working capital is an organization-wide priority, and that working capital improvements are linked to both business and individual performance.
Collaborate and coordinate across the organization—Since working capital touches so many different parts of an organization, CFOs should collaborate with other leaders within the business to make sure that the goal of improving working capital is embedded into the organization’s system, analytics, and performance metrics.
Identify optimization levers and use them consistently—There are levers throughout an organization that can help drive working capital improvements, such as more efficient inventory management, embedding specific working capital metrics in forecasting, and improved management of working capital items. Companies have to understand which levers may be more effective and then use them consistently.
Measure effectiveness with metrics—Metrics should be built into the optimization program’s goals and used as a constant feedback mechanism so that Financial Planning & Analysis and Treasury can monitor the program’s effectiveness and impact on, for example, the cost of capital.
Align incentives with improvement—To sustain working capital improvements, there should be incentives that foster management focus and changes. Incentives should be made available throughout the organization, and there should be tangible linkages to business performance and overall compensation, as well as flexibility to adjust for external factors that may adversely affect working capital.
The reasons to consider these suggestions are compelling. Efficient management of working capital can potentially free up cash for other activities that can fuel growth, ultimately increasing shareholder value.
Companies are always searching for opportunities and formulating strategies that will have a positive impact on business and contribute to its long-term success. There may be no better place to start looking for those opportunities than in working capital.
The author is a Director with the Audit & Assurance division of Navarro Amper & Co., the local member firm of Deloitte Southeast Asia Ltd., a member firm of Deloitte Touche Tohmatsu Limited—comprising Deloitte practices operating in Brunei, Cambodia, Guam, Indonesia, Lao PDR, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.