The current “great” recession and resulting credit crunch have launched financial professionals into uncharted waters. Nearly one in three large companies indicate that limited short-term credit availability has forced capital spending cuts, frozen or reduced hiring, forced staff layoffs, and compelled cutbacks in inventory along with store and factory closings. For many organizations, these and other factors may threaten their very survival.
In this environment, financial professionals who are able to manage working capital at an optimal level can enable their organizations to survive and gain market share. Strong working capital management can act as a hedge against negative macroeconomic forces such as diminished access to capital. Working capital management is a critical factor in achieving operational sustainability in the current environment as well as to emerging in a stronger competitive position after the recession.
The magnitude of this task today should not be underestimated. During times of certainty, it is easier to forecast working capital needs and manage liquidity. However, amid uncertain times with unpredictable economic pressures, management and financial professionals must devote themselves to reassessing the organization’s working capital sources and needs: What is the optimal level? How should it be financed? Does the organization have the proper controls to manage the business thereafter?
Defining Working Capital
The first step in optimizing working capital is to drive a working consensus on what exactly it is. There are many definitions of working capital, which can vary by industry. Some organizations choose to include only certain components that have the greatest impact on liquidity. For purposes of this discussion, working capital can be defined simply as current assets less current liabilities.
There are three primary components of working capital assets: (a) cash and marketable securities, (b) accounts receivable and (c) inventories. These assets provide the sources of income for the business, whether in the form of profit from the sale of products and services, or interest earned from securities. On the current liabilities side of the equation, accounts payable (A/P) is of particular importance, since the management of payables can significantly affect cash flow.
A goal of effective working capital management is ensuring sufficient cash flow to fund operations while reducing debt. Working capital management must be the responsibility of many outside the finance department. In fact, numerous aspects of working capital management stem from operational processes well beyond the control of finance. For example, the rate at which purchased materials and services are converted into sellable products will ultimately lead to the collection of cash (cash conversion cycle). Much of this conversion cycle can be influenced heavily by practices within the supply chain.
To reassess and improve management of working capital, organizations should undertake a four-step approach:
1.) Uncover sources of uncertainty. - Companies should begin by determining what new and existing risks they face and how those risks will have an impact on demands on working capital.
2.) Conduct a “working capital diagnostic.” - Companies can assess working capital effectively by analyzing data about their operations and benchmark to peers on percent of assets held in cash, cost of capital, average receivable and payable periods, and the length of the conversion cycle.
3.) Reassess working capital policy. - Working capital policy is a function of an organization’s business model and risk tolerance. These are used to determine whether current risks allow for an aggressive, moderate or conservative policy. An organization must consider all scenarios in light of the business, customer base and ability to finance current assets with short-term credit.
4.) Optimize working capital. - Optimizing working capital also is a function of the organization’s business model and risk tolerance. Opportunities to optimize working capital exist in areas including cash and marketable securities, accounts payable, accounts receivable and inventory.
How Protiviti is Helping Companies Meet This Challenge
We are urging companies to be proactive and strategic in their ongoing efforts to manage cost and working capital. There are often some “easy-wins,” which companies can quickly put in place to realize financial benefits. These may be related to contracts, the A/P process, other financial processes or technology.
Our professionals can help you evaluate the opportunities that exist throughout your business. We provide you with recommendations that outline the cost/benefit horizon for these opportunities. For example, small changes to "Days Working Capital" (DWC) can have a significant impact on available cash. Our professionals can show you how much additional cash would be available to your company if you reduce DWC by just one day and demonstrate the net impact to your bottom line.
To analyze key processes and identify opportunities for improvement, our professionals utilize proprietary methodologies and tools. These tools include fully integrated process-based applications designed to define key metrics and targets for working capital management, measurement of results and validation of benefits. Protiviti is the only business and risk consulting firm in the world with access to these powerful tools and our professionals have been using them to deliver a competitive advantage to our clients during this challenging time.