Working Capital Management

Why Working Capital Is Important?

Working capital is a key metric used by Wall Street to measure public company performance. Meanwhile, a lot of CEOs emphasized to deploy balance sheet more aggressively. One of the key approaches is working capital management. Well managed working capital helps to maintain a solid balance sheet and strong credit rating. Any cash occupied in working capital doesn’t help us to invest or return value to shareowners thus we must continue to reduce working capital so as to increase free cash flow. On the other hand, good working capital performance is indicative of a well-run business since working capital is the amount of cash tied up in the day-to-day operations of a business. It involves the whole cash cycle and operating cycle.

How Working Capital Being Measured?

Working capital equals current assets minus current liability. That is Accounts Receivable (AR) plus inventory minus Accounts Payable (AP) and Advances.

The efficiency of Working Capital is measured by working capital 13-point turns. It equals 12 months rolling sales divide average 13-month working capital balance. The quicker on turns, the wiser on working capital uses.

Working capital is also being measured by the following key metrics.

Days Sales Outstanding (DSO)

Number of Days Sales Contained in Accounts Receivables Balance, Includes Unbilled, Advances and bank draft. It indicates whether collecting from customers is fast enough.

Days of Supply (DOS)

Number of Days Cost of Goods Sold (COGS) Contained in Inventory Balance. It indicates how fast the inventory is turned into sales.

Days’ Purchases in Payables (DPP)

Number of Days COGS Contained in Accounts Payables Balance. It indicates whether paying suppliers is too fast or too slow.

The Cash Conversion Cycle (CCC) = DSO + DOS – DPP

Working Capital Management Best Practices Sharing

Leadership Focus

Finance team provide the analysis of working capital Key Performance Indicators (KPI) and trends monthly. These KPIs are reviewed by senior management in business operation review meeting monthly. Any identified issues will be taken quick actions. Furthermore, General Manager and business leaders lead top Accounts Receivable review by customer weekly.

Cross-Function Cooperation

The engagement from various teams helps to improve working capital efficiency greatly, especially on AR and inventory management. For example, commercial finance team work with Customer to Cash (C2C) team on contract early stage negotiation and credit check. It ensures the payment term can better negotiate and review before contract is signed and avoid doing business with high risk customers as well. Furthermore, milestone control is enhanced too. Down payment is requested for all contracts, say 10%-30%, it not only helps on working capital but also reduces risk of company. Moreover, cap on key milestones, such as Site Acceptance Testing (SAT) is stipulated in the contract to be either SAT signed or 6 months from shipment whichever is earlier, it helps to avoid disputes in the future and provide a clear base of on time billing.

Another example of cross function cooperation is from Sales Inventory Operation Plan (SIOP) and key projects tracking. It involves Order Management Team (OMT), Supply Chain, business leaders, and finance. The well communicated demand plan, production plan, and supply plan ensure correct inventory forecast, on-time delivery and consistent quality.

Along with macro economy recession in recent two years, more and more customers are facing cash liquidity challenges and paying by bank draft. Bank draft is not cash, it is just another kind of account receivable until it matures. Moreover, the company takes the risk that those unqualified bank drafts can’t turn into cash. The company needs to be strict with bank draft policy & execution and work with procurement to endorse bank drafts received to top suppliers if possible. It will further help the company future working capital efficiency.

Conclusions

Good working capital management is the result of strong processes. In real business, we can’t concentrate on one or two metrics health but neglect other factors. All metrics need to be well balanced. For example, we can involve 3rd party agent to collect long aging past due. However, we need to consider it carefully if it is really necessary since it will damage customer relationship.

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