Working capital (or sometimes called net working capital) is the difference between current assets and current liabilities. It is sometimes expressed as a ratio of one divided by the other where anything greater than 1 is supposed to be good (the higher, the better). The main reason we calculate net working capital is to determine a company’s ability to meet its short-term obligations. However, as I learned years ago, simply examining net working capital or its ratios doesn’t tell the full story. To really understand how a company is performing, we have to scrutinize the individual balance sheet line items to get the full picture. More specifically, we have to carefully examine the current asset line items—cash and equivalents, accounts receivable and inventory to get a clearer picture on how the company is performing.
First of all, cash is cash. It doesn’t really bear further investigation unless the company is investing in exotic instruments or junk bonds that carry market and credit risk. Otherwise we can take the cash line item at face value. To really find what lurks below the surface, we have to look at accounts receivable and inventory as key components of a company’s operating cycle, then we can start to deconstruct it and make assessments on how the company is performing. The operating cycle begins and ends with cash but moves through production, sales and billing. The company buys raw materials, moves them through production (work in progress) and then to finished goods inventory where they are available for sale. When inventory is sold, the company invoices its suppliers, creates an account receivable and finally, when the customer pays, they are converted to cash.
What about a high working capital ratio? It doesn’t always point to things going well—it means one or more of the current asset line items—cash, accounts receivable or inventory may be abnormally high and an indicator of trouble. In a later blog, I’ll discuss accounts receivable which have their own issues. In this blog, I will focus on inventory. The goal of a “product-based’ company—a manufacturer, wholesaler or retailer, is to strike a balance between demand and production.
Inventory can be one of the riskier assets because it represents a use of cash and the company has relatively little control over managing it. Demand forecasting is still more art than science as are the decisions on what to build and in what quantity. The risk of not producing enough is a stock out. Running out stock is means lost sales, reduced cash flow and potentially sending business to a competitor. Too much inventory increases the risk of obsolescence and may trigger a costly write off. To underscore the latter, a recent article in CFO Magazine outlined some of the alternatives for disposing of obsolete inventory and one of the options was selling it on eBay! (http://www3.cfo.com/article/2013/8/supply-chain_excess-inventory-section-c-corporation-irs-ebay-landfill).
On the broader topic of inventory as a component of working capital, CFO recently published their annual working capital survey (http://www3.cfo.com/article/2011/7/capital-markets_easing-the-squeeze-2011-working-capital-survey-cash-flow) and identified inventory as the chief culprit behind excess working capital. In fact, inventory accounts for 43% of excess working capital. What makes inventory so problematic is that of all the elements of working capital it is the most difficult to control. In other words, the finance staff has more options to control accounts receivable and accounts payable than they do with inventory. The issues are many. Some companies increase safety stock in anticipation of higher sales. Without that stock they risk not being able to meet customer demand. However, more stock increases risk and if sales don’t materialize, at best the excess inventory represents tied up cash. At worst, it can mean a costly write off.
How can companies do a better job of balancing the tradeoffs and minimizing their inventory risk? Integrated IT systems can help. Applications that help sharpen sales forecasts that feed into production planning and supply chain systems can remove a great deal of the guesswork in ordering raw materials and scheduling shop floor activities. Systems that manage design and bills of material for each product can strive to design products with greater parts commonality can help the company be more nimble in shifting production of one product to another in response to changing demand. They also help reduce obsolescence risk. Finally, supply chain systems can help manage company’s myriad suppliers to ensure they have multiple sources that can respond to changing demand patterns and employ “just-in-time” ordering. Optimizing inventory is a challenge for all the reasons I’ve cited above. It’s also difficult because many departments across the business have a hand in determining production and achieving coordination across them isn’t always easy. Finance departments can help by educating the various players about the need for liquidity and healthy cash flow as well as the risks posed by excess inventory. Finance can be a key partner in helping line managers make better decisions that result in improved financial performance. It’s a “win-win” for everyone.