Part 1 in a 2-part series
Now more than ever, organizations depend on treasurers to be the fiscal watchdog. Most critically, treasurers are asked to be the steward of the company’s most important asset: cash. Everyone knows this asset is the lifeblood of an organization, propelling the generation of goods and services and the rewards that come along with their delivery. Treasurers also keep the organization running smoothly by forecasting what financial flexibility the organization can rely on through various business cycles. Because when cash runs out, or if there’s even a question about liquidity, production is thrown off, or worse, grinds to a halt.
In this post, we’ll take a look at age-old, tried-and-true methods to measure working capital and some simple ways to improve it. But we’ll also dive a bit deeper on new derivations of those strategies, mainly driven by enhancements in technology that make it easier than ever to achieve improvement.
The mission seems simple enough
At the core, treasurers strive to continuously improve and efficiently manage working capital and generate cash flows. While the mission seems simple, in practice and with competing priorities, it can be difficult to deploy. Knowing where the company stands on working capital performance, how it compares to peers, the upside of improving, assembling a project team to make the improvements, and sustaining that change over time are not simple tasks. There are three parts to the framework that most companies use to improve working capital performance.
- Gathering data and benchmarks for key financial metrics to assess performance and areas of improvement in working capital
- Assessing, selecting, implementing, and utilizing solutions and best practices to solve issues and improve the performance of working capital
- Deploying working capital savings back into the business to fund projects, investments, or pay down debt
In this post, we will focus on the first two parts of this framework.
Gathering data and benchmarks
Working capital ratios and benchmarks are not new news, but these simple ratios can get lost and overlooked. The benefits of managing them tightly are simple ways to enhance overall financial performance.
There are three key performance indicators that capture working capital efficiency:
- Current ratio
- Turnover ratio
- Cash conversion cycle
We will unpack each of these metrics to illustrate their benefits and remind ourselves of their power.
First, treasurers will look at their current ratio versus peers and historical performance to get a rough estimate of the company’s liquidity and working capital efficiency. This key ratio measures a company’s working capital (current assets over current liabilities). Here’s how that breaks down:
<1.0 Signals a company may have trouble settling current obligations in a crisis
1.0 Reasonable for liquidity purposes as it indicates that current assets are enough to cover current obligations
1.2 – 2.0 Ratio most business analysts believe to be considered satisfactory
>3.0 Indicates that a company’s assets, working capital, or even ability to secure debt financing are not being managed efficiently
Treasurers are reacting and directing meaningful changes throughout their organizations to improve these ratios by spearheading the management of the key levers of working capital (accounts receivable, inventory, and accounts payable). And their efforts are being noticed! According to the most recent Hackett Group Working Capital Survey, in 2017, the 1,000 largest U.S.–based public companies had their best working capital performance since 2008. U.S. companies executed working capital efficiencies mostly by extending payables in reaction to the approaching headwinds of rising interest rates and escalating raw materials costs impacted by inflation and global tariffs. Efforts were also made to harvest the balance sheet to support increased merger and acquisition (M&A) activity, capital expense spending, and returns to shareholders in the form of increased dividends.
Second, treasurers will review the turnover ratio to measure how efficiently the company is deploying its working capital to support sales relative to peers and historical performance.
For example, a working capital turnover ratio of 5 indicates that the company is generating $5 of sales for every $1 of working capital deployed.
High ratio: Indicates the company is efficiently using current assets and liabilities to support sales
Low ratio: Indicates the company is tying up too much capital in AR and inventory to support sales
Analysts know that having excess capital tied up in uncollected AR can signify poor-quality receivables and issues with collections and chargebacks that foreshadow pending bad debt write-offs. In addition, excessive inventory could indicate weak demand for products, with the very real possibility that warehouse shelves are filled with obsolete inventory. In fact, these scenarios are playing out on the average company’s balance sheet. It’s clear that while the largest U.S.–based public companies are executing improvements in working capital, smaller companies and global competitors are losing ground. Dry powder is now sitting in the receivables and inventory of most companies’ balance sheets waiting to be uncorked.
Cash conversion cycle
Third, the importance of how AR, inventory, and AP drive a company’s cash conversion cycle cannot be overstated. This metric measures the time it takes to convert a cash outlay into a cash receipt. Treasurers also rely on this calculation to help identify and target what variables are causing inefficiencies in their working capital relative to peers and past performance.
The calculation is defined as days sales outstanding (DSO) PLUS days inventory outstanding (DIO) LESS days payable outstanding (DPO).
While companies have focused on DPO to enhance working capital, a vast quantity of dry powder still remains tied up in receivables and inventory. According to The Hackett Group, the 1,000 largest U.S.–based public companies in aggregate have continued to leave over $1 trillion in working capital on the balance sheet, forgoing the chance to decrease their cash conversion cycle. To illustrate the impact of this inefficiency, a seven-day cut in the cash conversion cycle could return about a 1% improvement in margin through lower write-offs of uncollected receivables, obsolete inventories, and exercising trade discounts. For companies generating an EBITDA of 5%, a 1% pick-up in margin equates to a 20% increase in profit.
In the next blog in this series, we’ll look at how to assess, select, implement, and utilize solutions and best practices.
To learn more about the best working capital and treasury management strategies, join us for our upcoming webinar: The Power of True Liquidity Positioning and Forecasting with a Treasury Management System. Register Now.