Getting the right working capital ratio
Working capital is often under-managed in businesses, primarily because its importance is not consistently recognized, says Hardik Sheth, partner and associate director of the Boston Consulting Group.
While a working capital ratio of between 1.2 and 2.0 is generally considered optimal, it is a mistake to assume that a ratio in this range is best suited for your operations, the specialists said. from cash management to CFO Dive.
Working capital differs between operations, but generally it is the difference between your current assets – cash flow, accounts receivable and, if you are a manufacturing company, inventories of raw materials and finished goods – and your current debts, mainly your accounts payable.
A rather high working capital count, like 1.7 or 1.8, essentially gives you more leeway to absorb large capital expenses, while being a bit more prepared for any sudden spells, Sheth said.
The outbreak of Covid-19 is the classic new example of an unexpected event that can make it crucial for you to keep your working capital ratio high, he suggested.
If your ratio is low, say 1.1 or 1.2, you can increase it quickly by keeping more revenue in reserve and delaying payments from vendors and the like – Basically, adjust your Cash Conversion Cycle (CCC) by making tactical changes to your Selling Days Outstanding (DSO), Outstanding Payable Days (DPO) and, for manufacturers, Outstanding Stock Days (DIO) ).
“How many days does it take to collect your accounts receivable compared to the number of days you take to settle your accounts payable?” said Dana Johnson, a Grant Thornton alumnus who teaches at Michigan Technological University and speaks frequently about working capital at American Institute of CPA (AICPA) events. “What are the average collection and payment days for your industry? If inventory is the problem, is there an obsolescence issue or is there a mismatch between demand and supply? What are the general inventory levels for your industry? “
Hackett Group Associate Director Craig Bailey said focusing on CCC may be more helpful than looking at the ratio because it keeps you focused on the three key drivers of working capital performance – receivables. , stocks and debts.
“Measuring CCC helps set or adjust goals and helps a CFO easily identify priority areas of risk and opportunity areas,” he said. “Typically, the cash conversion cycle will give a better picture of a company’s cash flow than the working capital ratio. ”
For businesses constantly struggling with too much inventory, there are a few quick fixes worth considering, Bailey said. First of these: segment stocks by demand behaviors to identify slow moving stocks that inflate the value of stocks and are threatened with obsolescence.
Another approach is to create short-term project teams to resolve issues. These could include demand consolidation, adjusting the size of customer orders / manufacturing lots / supplier lots and make-to-order / buy-to-order strategies versus make / buy-to-stock strategies. , did he declare.
Increase the ratio
CCC considerations can also help if your problem is consistently too high a ratio.
If it’s near 2.0 or higher, it could indicate that you are shifting your short-term goals to mid- to long-term, Sheth said.
“We must promote the use of assets towards R&D, investment projects and other areas of investment,” he said.
For businesses with inventory to manage, your DIO can tell you if you’re holding inventory longer than optimal before converting it to sales, he said.
There could be several factors behind this, he added, including poor sales performance (inability to convert leads into orders) and insufficient regulation of production levels, among other environmental factors. or commercial.
Looking at working capital valuation technology, Sheth said it has come a long way and the requirements to make it work effectively are no longer as onerous as they once were.
As with so many technologies, however, the idea of garbage-in, garbage-out applies, so failure to review the information and data generated from the system in a timely manner can lead you to make decisions. based on bad data, Johnson said.
“The key indicators should be reviewed monthly to include the liquidity and activity ratios. Inventory rotation, average AR collection days, average AP payment days, etc. She said.
At the same time, she said, technology and working capital are a gray area with no single solution.