How Efficient Is Your Working Capital?
Businesses can no longer remain complacent and expect that eroding profitability be simply reversed with increases in sales prices, sales volumes, or both. Cost containment is now a central focal point, with the company financial microscope being focused on the costs that are required to generate sales in an endeavor to operate financially leaner, more efficient and consequently more profitably.
For product companies that require inventory holdings, one important cost measure is Working Capital Efficiency, or WCE. WCE is a measure of how efficiently the company’s capital is being utilized in terms of accounts receivables (AR), accounts payables (AP) and inventory, as a % of total sales. Simplistically, the higher the WCE %, the higher the day to day costs required to finance the businesses activities.
Formula
WCE = Accounts Receivable $ – Accounts Payable $ + Inventory $
Total Sales $
Where;
AR = 13 month moving average $
AP = 13 month moving average $
Inventory = 13 month moving average $
Total Sales = 12 month moving cumulative sales $
Analysing WCE exposes and dissects three independent but inter-related cost components involved with sourcing, storing and selling a product;
Accounts Receivable - Financial terms (days to receive payment) provided to customers.
Accounts Payables - Financial terms (days to make payment) for the purchasing of products.
Inventory Stock On Hand - Inventory management by way of inventory holdings to service product sales.
By focusing on these three cost components, WCE can be improved. Developing strategies to extend payments terms / cycles for suppliers, to reduce overall inventory levels and to reduce the number days to receive payments for customers will reduce WCE. So the longer it takes the company to pay for products, the fewer inventories the company requires to store, and the shorter the time taken to receive payment from customers, the better the WCE % and potentially less the capital required to finance activities.
WCE is a measure requiring focus and contribution from multiple departments including Finance, Sales Marketing and Purchasing. Unfortunately the required collaboration does not always occur until the metric is heading in the wrong direction and somebody needs to be held accountable.
As the Finance department manages AP and AR it often sets the associated WCE metric targets, possibly without consultation with departments fundamental to the metric. For example, establishing inventory targets without consultation can lead to unrealistic financial goals, as well as adding further and unanticipated costs. A knee-jerk reaction to quickly reduce inventory can trigger stock-outs, lost sales short term and potentially losing customers’ long term as customers look to source supply elsewhere. So while WCE may reduce, it is not necessarily beneficial or a sign of effective or efficient collaboration.
WCE is an important financial metric that if managed well will reduce operating costs and increase profitability. However it is a metric which requires a collaborative approach and culture where the contribution of all stakeholders is valued.
What working capital issues have you experienced?
What strategies have you found effective in reducing working capital?
Scott Pickering - is a consultant with Scopic Group Pty Ltd, with substantial experience assisting organisations to review capabilities and systems, re-engineer processes and implement cost reduction strategies. Need support and advice - contact 1300 723 761.
The information contained in this publication is intended as general commentary and should not be regarded or relied upon as financial or legal advice.
