One of the greatest challenges of business owners is the effective use of working capital. Working capital is essentially a business’s cash and other short-term, easily liquidated assets that can be used to fund day-to-day operations.
Smart Business spoke to Barbara Catherall, a senior audit manager at Tauber & Balser, P.C., about the importance and critical reasons of why CEOs and CFOs need to carefully monitor this constantly moving target.
What is working capital?
A businesses’ working capital is comprosed of the short-term assets required to conduct its day-to-day operations. Working capital is converted into cash for general operating purposes and certain capital needs. It’s then used to purchase inventory, obtain raw materials and fashion finished goods, which are then sold to customers. The heart of a business’s working capital is cash on hand plus accounts receivable plus inventory, less accounts payable and other short-term accrued liabilities.
In what ways can working capital management be evaluated?
Days Sales Outstanding (DSO) is an excellent indicator of working capital management. It provides management with a metric for the number of days that the company takes to collect payment after making a sale. A higher DSO indicates longer collection periods to obtain its cash, which has ramifications on cash flow, hindering the company’s ability to fund short-term obligations, such as accounts payable. Well-managed companies expect to have a DSO in the area of 30 days.
Days Inventory Outstanding provides a metric for the number of days that it takes to get inventory in and out of the door.
Days Payable Outstanding is an indicator of how long it takes from receipt of goods and services/inventory, to the time cash payment is made to its vendors. Higher is better, but be very careful not to impede your relationships with vendors.
Days Working Capital This metric culminates the entire objective of strong working capital management. It considers key short-term asset management as a whole, such that the lower the number the better, since it measures the time that it takes to turn inventory/sales into cash.
What are some techniques for better management of working capital?
Efforts to improve working capital revolve around two issues: processes and people. Regarding accounts receivable, the company should consider how it has communicated with customers. Are there different ways collection personnel might be able to converse with the customer to obtain payment? Would more frequent collection calls be appropriate, or are there other or better follow-up mechanisms? Perhaps stronger collections could be achieved through a third party.
Also, the company should investigate its credit policies and procedures. Collections are generally quite difficult when the sale has been made to a customer with poor credit. Thus, prior to the sale, it is suggested that an entity perform credit checks on its customers.
Another opportunity arises from strong inventory management, also known as supply chain management. Many companies have perpetual inventory systems that are not fully utilized. Not only will many of these systems provide basic inventory data, but they can also provide valuable information to management for forecasting. These systems often have the ability to track sales and develop economic order points and quantities that will result in reducing inventory balances without impairing the ability to service customers. In fact, sometimes, the correlation of sales data with inventory data will improve customer service.
Could a company involve its suppliers in strengthening working capital management?
Yes — they can and should. While delaying payments on accounts payable is an alternative, this cannot be stretched too far without damaging key relationships.
Are all companies the same?
Some companies have stronger cash flows for various reasons, such as receiving cash in advance of the sale. Many companies, however, do not have this luxury. Consider the metrics described above and compare your company’s key performance indicators with those of other companies in your industry. And, even more importantly, pay particular attention to monitoring your own working capital over time to evaluate improvements in your corporate processes.
Incentive-based compensation can motivate employees to participate in the rewards of cash management and working capital efficiency. Bonuses that consider improvements in asset management benefit both the company and the employee — a win, win for all. Consider this when designing your overall corporate policies, and you may be surprised how happy your employees will be in helping you drive corporate profits.
BARBARA CATHERALL is a senior manager providing service to both the Forensic and Audit departments at Tauber & Balser, P.C. She has more than 20 years of public accounting experience for both publicly and privately-held companies in the professional services, retail, wholesale distribution, manufacturing, health care, real estate, not-for-profit and construction industries. Reach her at [email protected] or (404) 814-4961.
