Working Capital Management

In a business that has never managed it, working capital is whatever the bank balance leaves. Customers pay when they choose. Suppliers are paid when there is money, sometimes early because the invoice was on top of the pile, sometimes late because it was not. Stock is bought when it is cheap, or when someone worries about running out. Nobody can say what level of working capital the business normally needs, because nobody has measured it the same way twice. When the business is sold, that unmeasured number is the one buyer and seller argue about longest, because it decides how much cash the seller has to leave in the business at closing.

Working Capital Management settles the number before anyone has to argue about it. It defines net working capital consistently, sets the level the business normally needs to carry, and manages receivables, payables and inventory to targets, so that the change a buyer deducts is small, predictable and agreed. With it in place, buyer and seller can agree a peg from the history in an afternoon.

One definition, applied every month

The foundation is two years of month-end net working capital on one written definition, agreed with the outside accountant, that excludes cash, debt and anything that behaves like debt.

The definition is written account by account. Every account on the balance sheet is assigned to working capital, cash, debt, debt-like or excluded, and the assignment is recorded so that it cannot move from month to month. Two years of month-end balances are then computed from the closed statements in one table, with receivables, inventory, payables, accruals and deferred revenue shown separately.

Without the definition, the peg means nothing. A business that counts customer deposits as working capital one month and as debt the next can make its working capital look like almost anything, and a buyer who notices the definition shifting assumes it shifts in the seller's favour. One written assignment, applied the same way every month, gives both sides a single number to argue from, and in practice they find far less to argue about.

A peg from the record

The peg is the level of working capital the business delivers at closing. It is set at the trailing year's average, adjusted for growth and seasonality with every adjustment written down, and the business has to show working capital close to the peg's seasonal expectation in nearly every month of the latest year.

Each month's working capital is expressed as a share of that month's revenue, which makes the seasonal curve visible and lets the expected level for any month be stated. The plain average is then adjusted for whatever the record shows has changed, such as growth, one unusually large order, or a supplier's change of terms, and each adjustment cites the record it relies on.

This turns the adjustment at closing into a figure both sides can calculate in advance, and the seller gains the most from that. Working capital delivered below the peg comes off the price dollar for dollar, so a peg set from a high month, or from a year in which collections slipped, is a level the seller has to fill with cash at closing. A peg set from managed days and a documented seasonal curve is a level the business delivers in the ordinary course.

Days managed to targets

Receivable days, payable days and inventory days each get a target, set from the business's own best year and its terms of trade, managed weekly by a named seat, and held within target over recent months.

Each has its habits. Invoices leave the day the work is done, reminders go out on a fixed schedule of days past due, and accounts beyond terms are put on hold by the seat responsible. The owner chasing a favoured customer is exactly the habit this replaces: owners chase selectively, and favoured customers learn that they can pay late. Suppliers are paid on the agreed due date, and terms are renegotiated wherever the business is paying faster than its peers without a discount for it. Stock is ordered against a reorder point and quantity computed from a year of usage, so that it is bought for demand, whatever the price or the worry of the moment. Once these habits hold, cash conversion is something the business produces on purpose, and a buyer has less reason to treat a good year as luck.

The cycle, and its limits

The three targets add up to one figure, sometimes called the cash conversion cycle: receivable days plus inventory days, less payable days. It counts the days a dollar spent on operations stays tied up before it comes back as cash from a customer. A business that collects in 45 days, holds 40 days of stock and pays its suppliers in 30 has a cycle of 55 days. Every day the cycle shortens is a day of the business's costs it no longer has to finance.

Each component has a limit. Stretching suppliers beyond their terms shortens the cycle on paper, but a buyer treats the overdue part as debt, and suppliers who are paid late eventually supply late, or stop supplying. Collecting faster can mean early-payment discounts that cost more than they are worth. Holding less stock saves cash until the business runs out of what customers want. So each target comes from the business's own best twelve months and its agreed terms of trade, and the aim is a level the record shows the business can sustain. A squeeze for one season to impress a buyer is undone by the peg at closing anyway.

What it does to value

Working Capital Management ranks first on this bridge. The cash it releases as days fall to target is real, arrives once, and is often large relative to the effort. And because a growing business has to build working capital in proportion to its revenue, every day removed also lowers what each year of growth absorbs, for as long as the business grows.

In the illustration, removing ten days of working capital from a business with $12 million of revenue releases about $329,000 at once, and at 5 percent growth it cuts the working capital that growth absorbs by about $16,000 a year. Valued together at a 12 percent cost of capital, the change is worth about $564,000. Nothing goes in the price column for this driver. The business really does need less capital to produce the same cash, so the whole effect is value.

What has to be in place first

Working capital is a balance-sheet measure and cannot be computed from a cash-basis profit and loss, so it needs two years of closed accrual balance sheets from Books. Weekly management of receivables and payables needs a finance seat with the time for it, from Management Install. And days can only be managed against terms somebody wrote down, which means written terms of trade on every customer and supplier contract, from Relationship Transfer.

Knowing that it works

The driver is tracked weekly by receivable, payable and inventory days against target, and by receivables beyond terms in dollars and as a share of the total, and monthly by net working capital against the peg's seasonal expectation, as a percentage variance.

The owner can be tested two ways. Ask for the peg and this month's variance from the table, without the finance seat, and for the largest single reason behind the variance. Then have whoever is running the crossing take a buyer's position on the definition and the adjustments for an hour and negotiate the peg against the owner. Every point the owner cannot defend from the records is fixed in the definition or the evidence before a real buyer raises it.

Why it slips, and what holds it

Working capital balloons slowly. Days creep up one customer and one reorder at a time, until cash conversion has fallen and nobody decided it should. Reporting the days in every monthly package, against targets the finance seat owns, shows a drift in any of the three in the month it starts. And credit holds and reorder points set in the systems stop an account beyond terms and block stock above its reorder point because the system says so, which survives a change of staff and a busy quarter.