Working Capital ProductivityHowever expressed or calculated, working capital productivity is a measurement that offers a snapshot of a company’s efficiency by comparing working capital with sales or turnover.

What It Measures

How effectively a company’s management is using its working capital.

Why It Is Important

It is obvious that capital not being put to work properly is being wasted, which is certainly not in investors’ best interests.

As an expression of how effectively a company spends its available funds compared with sales or turnover, the working capital productivity figure helps to establish a clear relationship between its financial performance and process improvement. The relationship is said to have been first observed by the US management consultant George Stalk while working in Japan.A seldom-used reciprocal calculation, the working capital turnover or working capital to sales ratio, expresses the same relationship in a different way.

How It Works in Practice

To calculate working capital productivity, first subtract current liabilities from current assets, which is the formula for working capital, then divide this figure into sales for the period.

Working capital productivity = Sales ÷ (Current assets – Current liabilities)

If sales are $3,250, current assets are $900, and current liabilities are $650, then:

3250 ÷ (900 – 650) = 3250 ÷ 250 = 13

In this case, the higher the number the better. Sales growing faster than the resources required to generate them is a clear sign of efficiency and, by definition, productivity.

The working capital to sales ratio uses the same figures, but in reverse:

Working capital/sales ratio = Working capital ÷ Sales

Using the same figures in the example above, this ratio would be calculated:

250 ÷ 3250 = 0.077 = 7.7%

For this ratio, obviously, the lower the number the better.

Tricks of the Trade

By itself, a single ratio means little; a series of them—several quarters’ worth, for example—indicates a trend, and means a great deal.

Some experts recommend doing quarterly calculations and averaging them for a given year to arrive at the most reliable number.

Either ratio also helps a management compare its performance with that of competitors. These ratios should also help to motivate companies to improve processes, such as

eliminating steps in the handling of materials and bill collection, and shortening product design times. Such improvements reduce costs and make working capital available for other tasks.

Working Capital CycleThe working capital cycle measures the amount of time that elapses between the moment when your business begins investing money in a product or service, and the moment the business receives payment for that product or service. This doesn’t necessarily begin when you manufacture a product—businesses often invest money in products when they hire people to produce goods, or when they buy raw materials.

Why It Is Important

A good working capital cycle balances incoming and outgoing payments to maximize working capital. Simply put, you need to know you can afford to research, produce, and sell your product.

A short working capital cycle suggests a business has good cash flow. For example, a company that pays contractors in 7 days but takes 30 days to collect payments has 23 days of working capital to fund—also known as having a working capital cycle of 23 days. Amazon.com, in contrast, collects money before it pays for goods. This means the company has a negative working capital cycle and has more capital available to fund growth. For a business to grow, it needs access to cash—and being able to free up cash from the working capital cycle is cheaper than other sources of finance, such as loans.

How It Works in Practice

The key to understanding a company’s working capital cycle is to know where payments are collected and made, and to identify areas where the cycle is stretched—and can potentially be reduced.

The working capital cycle is a diagram rather than a mathematical calculation. The cycle shows all the cash coming in to the business, what it is used for, and how it leaves the business (i.e., what it is spent on).

A simple working capital cycle diagram is shown in Figure 1. The arrows in the diagram show the movement of assets through the business—including cash, but also other assets such as raw materials and finished goods. Each item represents a reservoir of assets—for example, cash into the business is converted into labor. The working capital cycle will break down if there is not a supply of assets moving continually through the cycle (known as a liquidity crisis).

Figure 1. A simple working capital cycle diagram

The working capital diagram should be customized to show the way capital moves around your business. More complex diagrams might include incoming assets such as cash payments, interest payments, loans, and equity. Items that commonly absorb cash would be labor, inventory, and suppliers.

The key thing to model is the time lag between each item on the diagram. For some businesses, there may be a very long delay between making the product and receiving cash from sales. Others may need to purchase raw materials a long time before the product can be manufactured. Once you have this information, it is possible to calculate your total working capital cycle, and potentially identify where time lags within the cycle can be reduced or eliminated.

Tricks of the Trade

For investors, the working capital cycle is most relevant when analyzing capital-intensive businesses where cash flow is used to buy inventory. Typically, the working capital cycle of retailers, consumer goods, and consumer goods manufacturers is critical to their success.

The working capital cycle should be considered alongside the cash conversion cycle—a measure of working capital efficiency that gives clues about the average number of days that working capital is invested in the operating cycle.

Mergers and Acquisitions: Today’s Catalyst Is Working Capital

Executive Summary

In developed economies M&As are now used to acquire balance sheet assets, particularly cash hoards and other working capital; previously, M&A was oriented to strategic diversification or integration.

Although the volume of deals is down due to global economic conditions, the premiums paid for companies remain robust.

Acquirers appear to understand the risk inherent in these transactions, including the threat of investigation by US, EU, and Japanese regulators.

Until the recent problems with lines of credit provided by banks, many companies held excessive amounts of liquidity, making them vulnerable to unfriendly takeovers.

Various consulting companies have international practices in working capital management, including advising on mergers and assisting management to achieve efficiencies after the deal is completed.

Global M&A looks for the following characteristics: a high current assets-to-revenue relationship; a holding of cash that is not likely to be applied to business operations; and a proven income stream that should provide adequate cash flow to pay down borrowings used to provide financing for an acquisition.

Inefficient Working Capital Management

Working capital (WC) is defined as current assets less current liabilities; in this section we will focus on current assets other than cash. In the last four decades of the previous century, the percentage of WC as a percentage of sales declined by three-fourths. Although this represents a significant improvement in the management of these balance sheet accounts, estimates are that the total of excess WC may still exceed $600 billion.

There are merger opportunities in acquiring companies with excess WC and managing these accounts so that it approaches as close to zero as possible. The concept of WC as a hindrance to financial performance is a complete change in attitude from the conventional wisdom before the turn of the 21st century. However, WC has never contributed to a company’s profits; instead, it just sits on the balance sheet awaiting disposition. The Checklist box gives some ideas for working capital management.

Various consulting companies have developed international practices in working capital management, including advising on mergers and assisting management to achieve efficiencies once the deal has been completed. For example, REI is a US-based advisery services organization that has developed a global brand in WC services. REI has enabled clients in more than 60 countries to free up over $25 billion through optimization of working capital in the last 10 years alone. FTI Consulting offers an array of services designed to help companies address

critical issues and improve performance prior to engaging advisery services for acquisitions, divestitures, and recapitalizations. There are several other firms that support M&A analyses while assisting the new management to squeeze efficiencies out of the current asset and/or current liability portions of the balance sheet.

Checklist of Working Capital Ideas

Accounts Receivable

The credit and collection process, no matter how aggressive, inevitably results in some uncollectable amounts. When faced with the cost of the credit review process, bad debt expenses, and the cost of credit and collections, some businesses outsource their collection activities to a factor. Factors purchase or lend money on accounts receivable based on an evaluation of the creditworthiness of prospective customers of the business calculated as a discount from the sale amount, usually about 3 to 4%. That is, the factor will receive the entire sales amount, the selling company having received 96 to 97% at the time that the buyer was accepted by the factor.

Receivables Collateralization

In collateralization, a receivables package is offered as a security to investors. The critical element is a periodic, predictable flow of cash in payment of debts, such as credit cards, automobile loans, equipment leases, healthcare receivables, health club fees, and airline ticket receivables.

The market for public collateralizations is in the hundreds of billions of dollars, which has driven the required interest return to investors to become competitive with bank lending arrangements. Initial costs are higher than bank loans because the services of several professionals are required: attorneys; commercial and/or investment bankers; accountants; rating agencies (when ratings are required); and income servicers. However, the advantage of receivables collateralization is substantial—the transformation of receivables into cash.

Inventory

Just-in-time (JIT) requires that required materials be in the place of manufacture or assembly at the appropriate time to minimize excess inventory and to reduce wastage and expense. JIT succeeds when there are: a limited number of transactions; few “disturbances” due to unscheduled downtime, depending instead on periodic maintenance; the grouping of production processes to reduce the movement of work-in-process; and a significant focus on quality control (QC). QC minimizes downtime and the holding of buffer or safety stock to replace defective materials.

In traditional JIT, the company owns the inventory of components and parts, assuring access as the next production operation begins. JIT as currently practiced places the materials at the manufacturing or assembly site, but title remains with the vendor until production begins. This relationship requires suppliers to optimize the stock of inventory, holding only those items that have been specified or are known to be required based on a statistical analysis of purchasing

history. Both the provider and the user of materials are forced to develop a strong partnering attitude and minimize the adversarial stance often observed between purchasing counterparties.

Accounts Payable

Inefficient payables pervade US business. Invoices presented for payment should be matched against purchase orders and receiving reports to determine that the vendor has met the terms and conditions of the order, and that materials were received in good condition and in the correct amount. In practice, invoices are often paid without ascertaining that all requirements have been met. In about one-third of all payables situations, no purchase order was ever issued, nor was there a contract or other written agreement as to price or specifications.

A substantial number of companies have inadequate policies regarding appropriate purchasing and accounts payables practices. For example:

Should the payment be released on the due date or some specified number of days after the due date?

Are all cash discounts to be taken, or only those that provide a stipulated discount? Can the requesting business unit choose the supplier, or does purchasing have the

authority to select vendors so as to maximize volume pricing? Has purchasing determined that approved vendors are legitimate businesses, with a

suitable record of providing goods and services to the business community?