Working Capital 301: Optimization Strategies

How to Optimize Working Capital

This is part 3 in a mini-series on working capital (check out part 1 here and part 2 here).

Let's recap the basics so far:

• What is working capital? Receivables (A/R) plus inventory minus payables (A/P). Don't forget to include credit cards.
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• Why is it important? Survival. Working capital kills businesses. Though if managed properly, it can be a competitive cash flow advantage.
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• Why does profit not equal cash flow? You guessed it, working capital. Technically there are some other factors like capex, depreciation, and potentially other non-cash expenses (for a later day).
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• How do you tame this beast? With metrics, ratios, and close scrutiny. Sorry, no magic formula.

With the basics covered, how do you spot warning signs in working capital?

Let's pull some real data from a real company here... what you're seeing below is 22 quarters (5.5 years) of data highlighting days inventory on hand and gross margin. Notice anything?

See the red line splitting 2 very distinct time periods?

The first period was producing solid gross margins (close to 35%) with inventory on hand at or below 100 days in all but 3 periods... the second period saw rising inventory and deteriorating gross margins (down to 35%).

Here is the resulting cash flow (on a rolling 12-month basis) during this timeframe:

Ouch. This company went from very cash generative to heavy cash outflows. And though they've recovered, it isn't back to previous levels.

What's the point here?

There were clear indicators of higher days inventory on hand in Chart 1 (immediately following the red line). That's plenty of time to notice and react to a business change. Plotting your data against your own historic performance and/or industry peers works! If you want the clearest picture of negative trends, use visuals like charts or graphs, and check your current period ratio against the past 6-12 time periods.

Remember – this works for receivables and payables too!

What are some strategies to tame working capital?

1. Set strict rules – go and look at your 12-24 month turnover/days ratios... set firm guardrails for your business and make it a point to stay within them
2. Slow pay vendors (within reason) – you can control when (certain) vendors get paid; know where you have flexibility and manage it within reason (note: this isn't a good long-term strategy... most suppliers will eventually stop doing business with you)
3. Push (harder) on collections – this is obvious but we all still struggle with it; who's looking to collect for your business on a daily basis?
4. Use ABC inventory analysis – try ranking products from best (A) to least (C) selling (easy to gather from sales data)… never run out of stock on A items but watch your C products like a hawk
5. Sell excess inventory – adding onto the ABC method, shed those slow moving C products when you know you have too much (yes, 12 months inventory for any product is too much)
6. Jack up prices – raising prices for your products/services usually turns into cash flow faster than any other tactic... this is another one that you can't act on too frequently

Homework

This week's assignment – Time to do some analysis. Over the past 2 weeks, we asked you to look at your ratios and check your cash flow statement to identify profit-to-cash differences.

Now it's time to plot a ratio (take your pick) over the past 12-18 months. Plot the average or industry benchmark too. See if you can identify a trendline.

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