Get the right working capital ratio

Working capital is often undermanaged in companies, primarily because its importance isn’t consistently recognized, says Hardik Sheth, partner and managing partner at Boston Consulting Group.

While a working capital ratio between 1.2 and 2.0 is generally considered optimal, it’s a mistake to assume that a ratio in this range is best for your operations, analysts said. cash management at CFO Dive.

Working capital differs by operation, but is generally the difference between your current assets — cash, accounts receivable and, if you are a manufacturing company, inventories of raw materials and finished products — and your current liabilities, mainly your accounts payable.

A high working capital number, like 1.7 or 1.8, essentially gives you more leeway to absorb any large capital expenditures, while also being a bit more prepared for any sudden episodes, 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.

Key influencers

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 to vendors and the like – essentially, adjusting your cash conversion cycle (CCC) by making tactical changes to your days of past due sales (DSO), days of past due payment (DPO) and, for manufacturers, days of open inventory (DIO).

“How many days does it take to collect your accounts receivable compared to the number of days it takes you to pay your accounts payable?” said Dana Johnson, a Grant Thornton alum 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 sector? If inventory is the problem, is there an obsolescence problem or is there a mismatch between demand and supply? What are generally inventory levels for your industry? »

Hackett Group Managing Partner Craig Bailey says focusing on CCC can be more useful than looking at the ratio because it allows you to focus on the three main factors influencing working capital performance. : receivables, inventories and debts.

“Measurement of CCC helps set or adjust goals and helps a CFO easily identify priority areas of risk and areas of opportunity,” he said. “Generally, the cash conversion cycle will give a better insight into a company’s liquidity than the working capital ratio.”

For businesses struggling with too much inventory, there are a few quick fixes worth considering, Bailey said. The first of these: segment inventory based on demand behaviors to identify slow-moving inventory that inflates inventory value and is at risk of being obsolete.

Another approach is to create short-term project teams to solve problems. These could include consolidating demand, adjusting customer orders/manufacturing batch/supplier batch sizing, and making/buying to order versus making/buying from stock, he said. .

Increase ratio

CCC considerations can also be useful if your problem is a ratio that is consistently too high.

If it’s near 2.0 or higher, it could indicate that you’re making changes to your medium- and long-term goals in the short term, Sheth said.

“The use of assets for R&D, capital projects and other areas of investment should be promoted,” he said.

For businesses with inventory to manage, your DIO can tell you if you’re holding inventory longer than optimal before converting it into sales, he said.

There could be several factors behind this, he added, including poor sales performance (inability to convert leads into orders) and failure to properly regulate production levels, among other environmental factors. or commercial terms.

Technological solutions

As for working capital valuation technology, Sheth said it has evolved well and the requirements to run it effectively are not as onerous as they used to be.

As with so many technologies, however, the idea of ​​garbage in, garbage out applies, so failure to review system-generated information and data in a timely manner can force you to make decisions based on poor data, Johnson said.

“Key metrics should be reviewed monthly to include liquidity and activity ratios. Inventory turnover, 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.