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 by transaction, but generally it’s the difference between your current assets – cash, accounts receivable and, if you are a manufacturing company, inventories of raw materials and finished goods – and your short-term debts, primarily your accounts payable.
A rather high working capital count, like 1.7 or 1.8, basically gives you more leeway to absorb any big capital expenses, while being a little better prepared for any sudden spells, said. Sheth.
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 – Essentially, by adjusting your Currency Conversion Cycle (CCC) by making tactical changes to your Sales Outstanding Days (DSO), Outstanding Payable Days (DPO) and, for manufacturers, Outstanding Days ( DIO).
“How many days does it take to collect your accounts receivable compared to the number of days you take to pay 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 the CCC may be more helpful than looking at the ratio, as it helps to stay focused on the top three factors influencing 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 liquidity than the working capital ratio. ”
For businesses struggling with too much inventory, there are a few quick fixes worth considering, Bailey said. First of them: 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 / production lots / supplier lots, and make-to-order strategies versus make / buy-to-order strategies. stock, he said.
Increase the ratio
Considerations from the CCC 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 need to 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 (unable to convert leads into orders) and insufficient regulation of production levels, among other environmental or business factors. .
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 entry and exit applies, so failure to review the information and data generated by the system in a timely manner can lead you to make decisions based on it. on bad data, Johnson said.
“The key indicators should be reviewed monthly to include 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.