Working Capital Management: Optimizing Liquidity and Efficiency

Cash Flow Control: The Art of Working Capital Management

Why Working capital management?

In the business world, investors are often interested in measuring the company’s short term solvency and liquidity besides its long term plans and future growth prospects. A company has to buy raw materials, pay salaries, bills, creditors etc. which requires a smooth cash flow. This is achieved through working capital management.

An efficient working capital management ensures optimum liquidity and fuels business activity leading to efficiency. It makes the manufacturing/production process smooth and efficient and ensures cordial relations with creditors and customers.

How can a business ensure an efficient WCM? How can it be tension free of its bills? How efficient it is in WCM?

Let us understand what is meant by ‘Working capital management’, how companies can ensure liquidity and efficiency through an efficient WCM and how efficient is a company’s WCM.

What is Working capital and WCM?

Working capital is the difference between the current assets and current liabilities of a business.

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Liquid assets include cash and cash equivalents (e.g. FD’s). Trade receivables include dues from customers, whereas trade payable refers to money owed to creditors.

A positive working capital indicates sufficiency of assets to meet liabilities whereas a negative working capital shows deficit. However a higher surplus may indicate that the company’s assets are underutilized.

 

Working capital management refes to overseeing and controlling the current assets and liabilities of a company to ensure liquidity to meet day to day expenses and ensure efficiency in business operations.

WCM involves the following:

1.    Liquidity management: Ensuring sufficient to cash to meet its day to day expenses and maintaining sufficient reserves to tackle any future contingencies or capital needs.

2.    Inventory management: Ensuring optimum levels of stock and sale to avoid underutilization.

3.    Accounts receivable and payable: Negotiating favorable terms from creditors and faster collection from debtors to reduce cash conversion cycle.

4.    Short term financing: Investing in short term instruments like commercial papers, short term loans, etc. to finance short term obligations and needs.

 

Requirement of working capital depends upon the industry to industry and type of business. A retail business or a company that has seasonal or fluctuating demand will have low working capital whereas manufacturing companies usually have higher demand for working capital due to long receivable cycle.

How can companies ensure an efficient WCM?

As an entrepreneur you must have an efficient WCM so that you pay your daily bills and your employees get their monthly wages. Let us look at several ways by which a business can improve its WCM efficiency:

 

1.    Accelerating accounts receivables: This may involve providing discounts on early payments, automating collection systems, digitizing invoicing, and maintain cordial relations over a long period with customers.

2.    Tightening accounts payable: This involves negotiating favorable terms with creditors, taking advantage of early payment discounts, etc. Effective communication and relationship building is the key here.

3.    Reduce operating costs: The business must identify areas where it can cut costs. It may be as in getting quality raw material at low costs, use of new tech, automated ERP’s etc.

4.    Cash flow forecasting and scenario planning: The Company shall accurately forecast cash flow requirements by analyzing historical and relevant data. Also it must forecast cash requirements for any future contingencies and make provisions.

5.    Improved Inventory Management: It shall ensure that only sufficient stock is bought by chalking the necessary requirements. Also inventory turnover and other relevant factors must be checked on periodic basis to find reason for excess inventory.

6.    Consider several financing options: A business shall consider several short term investment to options such as CP’s, loans, bonds, etc. to finance its short term liabilities. Diversification of investments will ensure timely liquidity and mitigating financial risk.

7.    Optimum use of technology: A business shall get hands on sophisticated tech to ensure better cash flow forecast and enhanced liquidity. Use of AI and Machine learning for repetitive tasks such as data entry, report generation helps save time and cost. Better cash flow forecasting and treasury softwares enable businesses to keep track of their solvency and cash requirements. Also it enables them to get relevant and timely data for forecasting. The business shall invest in a software or ERP system that reduces costs and time and improves efficiency. For e.g. Oracle, SAP, etc 

How to measure WCM efficiency?

As a value investor, get interested in knowing how your company manages its daily cash needs. Imagine you invest in a company that has a fair valuation, profits growing with good CAGR initially and so on, but later its short term debts and cash conversion cycle rises. It is a sign that the company struggles in meeting daily cash needs. Companies consider several metrics to measure its WCM efficiency in order to keep track of daily cash needs:

1.  ?Current ratio

It measures the solvency position of the company and is calculated by dividing current assets with current liabilities.

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A ratio lower than 1 indicates inability to meet short term obligations or liquidity deficits. A ratio of 2:1 is considered as ideal for solvency but higher may indicate underutilization of assets.

2.  Quick Ratio (Acid-Test)

The quick ratio refines the current ratio by excluding inventory. This ratio is particularly useful for businesses where inventory can't be easily sold for cash when needed. A quick ratio above 1.0 generally signifies a company has good short term solvency.

 

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3.  Cash conversion cycle

It is the duration within which money invested in inventory gets converted back into cash after sale. It enables a business to know how much time money is blocked in inventory till it sold. It is measured as following:

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DIO (Days inventory o/s) indicates how long it takes to process raw material into finished good and sell.