Access to funding in the moment it is needed can fast become a critical success factor for mid-market businesses. Yet turning on a funding tap is increasingly complicated by regulations that have constrained the ability of traditional lenders to provide liquidity at an affordable cost, complicated lender risk management strategies, and availability of private equity.
One avenue for mid-market companies to maximise business growth is to improve working capital management. That is, optimising the use of the capital already inside a business to make it work better to support the firm’s need for growth and expansion. A strong working capital management strategy helps a business cover its financial obligations while boosting earnings.
The objectives of working capital management
Working capital management is the act of controlling, handling, directing, and monitoring a business’s inventory, debtors, and creditors or the operating working capital cycle.
The primary purpose of working capital management is to let a company maintain sufficient cash flow to meet short-term operating costs and debt obligations. It aims to ensure a company can operate while generating enough cash to meet operational expenses and service debt.
Effective working capital management can provide a competitive advantage to a business allowing it to capitalise on growth opportunities without the need for external funding.
In the experience of the Saltire Capital Partners executive team, management teams are rewarded for their ability to hit budgets and forecasts based on profitability hurdles. Ironically, few companies set productivity targets for working capital efficiency. Even fewer businesses set working capital management goals or benchmarks to incentivise management to take the right actions to optimise working capital.
How to calculate net working capital (NWC)
As a financial metric, working capital is calculated by finding the difference between a company’s current assets and current liabilities. Understanding this difference lets companies ensure adequate liquidity to meet short-term financial obligations while keeping resources invested productively to meet longer-term financial goals.
As a financial metric, it is calculated as:
Net working capital (NWC) = current assets – current liabilities
At the operational level, net operating working capital is calculated as:
Operating net working capital (NWC) = debtors + inventory – creditors
The lag between buying and holding inventory to making a sale and collecting cash and settling creditors creates a timing difference between realising profit and cash flow.
Working capital absorption is typically the main reconciling difference between accounting profit and operating cash flow. This difference fundamentally drives what is referred to as the quality of a company’s earnings.
When a business grows rapidly, the timing difference between recognising profit and generating positive cash flow can create cash flow or liquidity problems. Operating net working capital expressed as a percentage of annualised sales is Working Capital Absorption. As a rule of thumb, if working capital absorption is greater than a business’s gross margin, every dollar of sale will cost the business cash flow rather than contribute to cash flow. This is also known as overtrading.
When working capital is expressed in terms of days, it is commonly referred to as the cash conversion cycle or cash-to-cash cycle (C2C).
The C2C cycle reflects the time in days it takes a company to convert sales to cash. The operating net working capital positions are translated into ‘days outstanding.’ The number of days cash is tied up in inventory and receivables or financed by the suppliers in accounts payable. The formula to calculate C2C is:
C2C = DIO + DSO – DPO
Where:
- Days inventories outstanding (DIO) = the average number of days inventory is held.
- Days of sales outstanding (DSO) = average number of days until customers pay a company.
- Days of accounts payables outstanding (DPO) = average number of days until a company pays its suppliers.
A healthy C2C is a short one. The lower your C2C, and a negative number is ideal, the less time your working capital is tied up and the greater liquidity in your business. If your C2C is a positive number, its best to keep it as low as possible. A positive C2C shows how many days your company’s working capital is tied up while you wait for accounts receivable to be paid. A high C2C is often inevitable if your business sells on credit and your customers have long payment terms of 60 or 90 days to settle debts.
Assessing your working capital needs: Saltire Capital Partners workshop.
Saltire Capital Partners is a trusted mid-market advisory firm bringing unparalleled expertise and network access to help clients achieve outstanding commercial success. We provide capital advisory services which includes debt and equity funding, transaction advisory services (business sale, acquisition and due diligence); and general corporate advisory services. We aim to provide high-quality advice and develop close, long-term client relationships.
If you’d like insight into your businesses working capital needs, Saltire provides a half day workshop in which we:
- work through an organization’s working capital needs with recommendations on obtaining and managing expansion financing and optimizing capital structure and debt; and
- provide insight into a Business’s C2C with as assessment of potential for improvement.