Working Capital Productivity

However expressed or calculated, working capital productivity is a measurement that offers a

snapshot of a company’s efficiency by comparing working capital with sales or turnover.

What It Measures
How effectively a company’s management is using its working capital.

Why It Is Important
It is obvious that capital not being put to work properly is being wasted, which is certainly not in
investors’ best interests.

As an expression of how effectively a company spends its available funds compared with sales
or turnover, the working capital productivity figure helps to establish a clear relationship
between its financial performance and process improvement. The relationship is said to have
been first observed by the US management consultant George Stalk while working in Japan.A
seldom-used reciprocal calculation, the working capital turnover or working capital to sales ratio,
expresses the same relationship in a different way.

How It Works in Practice

To calculate working capital productivity, first subtract current liabilities from current assets,
which is the formula for working capital, then divide this figure into sales for the period.

Working capital productivity = Sales ÷ (Current assets – Current liabilities)

If sales are $3,250, current assets are $900, and current liabilities are $650, then:

3250 ÷ (900 – 650) = 3250 ÷ 250 = 13

In this case, the higher the number the better. Sales growing faster than the resources required to
generate them is a clear sign of efficiency and, by definition, productivity.

The working capital to sales ratio uses the same figures, but in reverse:

Working capital/sales ratio = Working capital ÷ Sales

Using the same figures in the example above, this ratio would be calculated:
250 ÷ 3250 = 0.077 = 7.7%

For this ratio, obviously, the lower the number the better.

Tricks of the Trade

 By itself, a single ratio means little; a series of them—several quarters’ worth, for
example—indicates a trend, and means a great deal.
 Some experts recommend doing quarterly calculations and averaging them for a given
year to arrive at the most reliable number.
 Either ratio also helps a management compare its performance with that of competitors.
 These ratios should also help to motivate companies to improve processes, such as
eliminating steps in the handling of materials and bill collection, and shortening product
design times. Such improvements reduce costs and make working capital available for
other tasks.

Working Capital Cycle

The working capital cycle measures the amount of time that elapses between the moment when
your business begins investing money in a product or service, and the moment the business
receives payment for that product or service. This doesn’t necessarily begin when you
manufacture a product—businesses often invest money in products when they hire people to
produce goods, or when they buy raw materials.

Why It Is Important
A good working capital cycle balances incoming and outgoing payments to maximize working
capital. Simply put, you need to know you can afford to research, produce, and sell your product.

A short working capital cycle suggests a business has good cash flow. For example, a company
that pays contractors in 7 days but takes 30 days to collect payments has 23 days of working
capital to fund—also known as having a working capital cycle of 23 days. Amazon.com, in
contrast, collects money before it pays for goods. This means the company has a negative
working capital cycle and has more capital available to fund growth. For a business to grow, it
needs access to cash—and being able to free up cash from the working capital cycle is cheaper
than other sources of finance, such as loans.

How It Works in Practice

The key to understanding a company’s working capital cycle is to know where payments are
collected and made, and to identify areas where the cycle is stretched—and can potentially be
reduced.
The working capital cycle is a diagram rather than a mathematical calculation. The cycle shows
all the cash coming in to the business, what it is used for, and how it leaves the business (i.e.,
what it is spent on).

A simple working capital cycle diagram is shown in Figure 1. The arrows in the diagram show
the movement of assets through the business—including cash, but also other assets such as raw
materials and finished goods. Each item represents a reservoir of assets—for example, cash into
the business is converted into labor. The working capital cycle will break down if there is not a
supply of assets moving continually through the cycle (known as a liquidity crisis).

Figure 1. A simple working capital cycle diagram

The working capital diagram should be customized to show the way capital moves around your
business. More complex diagrams might include incoming assets such as cash payments, interest
payments, loans, and equity. Items that commonly absorb cash would be labor, inventory, and
suppliers.

The key thing to model is the time lag between each item on the diagram. For some businesses,
there may be a very long delay between making the product and receiving cash from sales.
Others may need to purchase raw materials a long time before the product can be manufactured.
Once you have this information, it is possible to calculate your total working capital cycle, and
potentially identify where time lags within the cycle can be reduced or eliminated.

Tricks of the Trade

 For investors, the working capital cycle is most relevant when analyzing capital-intensive
businesses where cash flow is used to buy inventory. Typically, the working capital cycle
of retailers, consumer goods, and consumer goods manufacturers is critical to their
success.
 The working capital cycle should be considered alongside the cash conversion cycle—a
measure of working capital efficiency that gives clues about the average number of days
that working capital is invested in the operating cycle.
Mergers and Acquisitions: Today’s Catalyst
Is Working Capital
Executive Summary
 In developed economies M&As are now used to acquire balance sheet assets, particularly
cash hoards and other working capital; previously, M&A was oriented to strategic
diversification or integration.

 Although the volume of deals is down due to global economic conditions, the premiums
paid for companies remain robust.

 Acquirers appear to understand the risk inherent in these transactions, including the threat
of investigation by US, EU, and Japanese regulators.

 Until the recent problems with lines of credit provided by banks, many companies held
excessive amounts of liquidity, making them vulnerable to unfriendly takeovers.

 Various consulting companies have international practices in working capital

management, including advising on mergers and assisting management to achieve
efficiencies after the deal is completed.

 Global M&A looks for the following characteristics: a high current assets-to-revenue
relationship; a holding of cash that is not likely to be applied to business operations; and a
proven income stream that should provide adequate cash flow to pay down borrowings
used to provide financing for an acquisition.

Inefficient Working Capital Management

Working capital (WC) is defined as current assets less current liabilities; in this section we will
focus on current assets other than cash. In the last four decades of the previous century, the
percentage of WC as a percentage of sales declined by three-fourths. Although this represents a
significant improvement in the management of these balance sheet accounts, estimates are that
the total of excess WC may still exceed $600 billion.

There are merger opportunities in acquiring companies with excess WC and managing these
accounts so that it approaches as close to zero as possible. The concept of WC as a hindrance to
financial performance is a complete change in attitude from the conventional wisdom before the
turn of the 21st century. However, WC has never contributed to a company’s profits; instead, it
just sits on the balance sheet awaiting disposition. The Checklist box gives some ideas for
working capital management.
Various consulting companies have developed international practices in working capital
management, including advising on mergers and assisting management to achieve efficiencies
once the deal has been completed. For example, REI is a US-based advisery services
organization that has developed a global brand in WC services. REI has enabled clients in more
than 60 countries to free up over $25 billion through optimization of working capital in the last
10 years alone. FTI Consulting offers an array of services designed to help companies address
critical issues and improve performance prior to engaging advisery services for acquisitions,
divestitures, and recapitalizations. There are several other firms that support M&A analyses
while assisting the new management to squeeze efficiencies out of the current asset and/or
current liability portions of the balance sheet.

Checklist of Working Capital Ideas

Accounts Receivable

The credit and collection process, no matter how aggressive, inevitably results in some
uncollectable amounts. When faced with the cost of the credit review process, bad debt expenses,
and the cost of credit and collections, some businesses outsource their collection activities to a
factor. Factors purchase or lend money on accounts receivable based on an evaluation of the
creditworthiness of prospective customers of the business calculated as a discount from the sale
amount, usually about 3 to 4%. That is, the factor will receive the entire sales amount, the selling
company having received 96 to 97% at the time that the buyer was accepted by the factor.

Receivables Collateralization

In collateralization, a receivables package is offered as a security to investors. The critical

element is a periodic, predictable flow of cash in payment of debts, such as credit cards,
automobile loans, equipment leases, healthcare receivables, health club fees, and airline ticket
receivables.

The market for public collateralizations is in the hundreds of billions of dollars, which has driven
the required interest return to investors to become competitive with bank lending arrangements.
Initial costs are higher than bank loans because the services of several professionals are required:
attorneys; commercial and/or investment bankers; accountants; rating agencies (when ratings are
required); and income servicers. However, the advantage of receivables collateralization is
substantial—the transformation of receivables into cash.

Inventory

Just-in-time (JIT) requires that required materials be in the place of manufacture or assembly at
the appropriate time to minimize excess inventory and to reduce wastage and expense. JIT
succeeds when there are: a limited number of transactions; few “disturbances” due to
unscheduled downtime, depending instead on periodic maintenance; the grouping of production
processes to reduce the movement of work-in-process; and a significant focus on quality control
(QC). QC minimizes downtime and the holding of buffer or safety stock to replace defective
materials.
In traditional JIT, the company owns the inventory of components and parts, assuring access as
the next production operation begins. JIT as currently practiced places the materials at the
manufacturing or assembly site, but title remains with the vendor until production begins. This
relationship requires suppliers to optimize the stock of inventory, holding only those items that
have been specified or are known to be required based on a statistical analysis of purchasing
history. Both the provider and the user of materials are forced to develop a strong partnering
attitude and minimize the adversarial stance often observed between purchasing counterparties.

Accounts Payable

Inefficient payables pervade US business. Invoices presented for payment should be matched
against purchase orders and receiving reports to determine that the vendor has met the terms and
conditions of the order, and that materials were received in good condition and in the correct
amount. In practice, invoices are often paid without ascertaining that all requirements have been
met. In about one-third of all payables situations, no purchase order was ever issued, nor was
there a contract or other written agreement as to price or specifications.

A substantial number of companies have inadequate policies regarding appropriate purchasing

and accounts payables practices. For example:

 Should the payment be released on the due date or some specified number of days after
the due date?

 Are all cash discounts to be taken, or only those that provide a stipulated discount?

 Can the requesting business unit choose the supplier, or does purchasing have the
authority to select vendors so as to maximize volume pricing?

 Has purchasing determined that approved vendors are legitimate businesses, with a
suitable record of providing goods and services to the business community?