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Working Capital – Strategy @ Risk

Strategy @ Risk

Series: Working Capital

Working Capital Strategy

This entry is part 1 of 3 in the series Working Capital

Passion is inversely proportional to the amount of real information available. See Benford’s law of controversy.

The annual “REL ((REL Consultancy. (2010). Wikipedia. Retrieved October 10, 2010, from http://en.wikipedia.org/wiki/REL_Consultancy)) /CFO Working Capital Survey” made its debut in 1997 in the CFO Magazine. The magazine identifies working capital management as one of the key issues facing financial executives in the 21st century (Filbeck, Krueger, & Preece, 2007).

The 2010 Working Capital scorecard (Katz, 2010) and its accompanying data ((http://www.cfo.com/media/201006/1006WCcompletev2.xls)) gives us an opportunity to look at working capital management ((Data from 1,000 of the largest U.S. public companies)); that is the effect of working capital management on the return on capital employed (ROCE):

or,

From the last formula we can see that – all else kept constant – a reduction in net operating working capital should imply an increased return on capital employed.

Gross and Net Operating Working Capital

A firm’s gross working capital comprises its total current assets. One part of it will consist of financial current assets held for various reasons other than operational, and the other part of receivables from operations and the inventory and cash necessary to run these operations. It is this last part that interests us.

The firm’s operations will have been long term financed by equity from owners and by loans from lenders. Firms usually also have short term financing from banks (short term credit + overdraft facilities/ credit lines) and most always from suppliers by trade credit. The rest of the current liabilities; current tax and dividends will not be considered as parts of operating current liabilities, since they comprises only non recurrent payments.

Net working capital is defined as the difference between current assets and current liabilities (see figure below). It can be both positive and negative depending on the firm’s strategic position in the market.

However usually a positive net working capital is required to ensure that the firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. In the following we assume that any positive net working capital is held as cash and that all excess cash is held as marketable securities.

By removing from both current assets and liabilities all items not directly related to and necessary for the operations, we arrive at net operating working capital as the difference between operating current assets and operating current liabilities:

Net operating working capital = Operating current assets – Operating current liabilities

Since the needed amount of working capital will differ between industries and be dependent on company size it will be easier to base comparisons on the cash conversion cycle.

Working Capital Management

Working capital management is the administration of current assets as well as current liabilities. It is the main part of a firm’s short-term financial planning since it involves the management of cash, inventory and accounts receivable. Therefore, working capital management will reflect the firm’s short-term financial performance.

Current assets often account for more than half of a company’s total assets and hence, represent a major investment for small firms as they can not be avoided in the same way as investments in fixed assets can – by renting or leasing. A large inventory will tie up capital but it prevents the company from lost sales or production stoppages due to stock-out. A high level of current assets hence means less risk to the company but also lower earnings due to higher capital tie-up – the risk-return trade-offs (Weston & Copeland, 1986).

Since the needed amount of working capital will differ between industries and also will be dependent on company size it will be easier to base comparisons of working capital management between companies and industries on their cash conversion cycle (CCC).

The Cash Conversion Cycle

The term “cash conversion cycle” (CCC) refers to the time span between a firm’s disbursing and collecting cash and will thus be ‘unrelated’ to the firm’s size, but be dependent on the firm’s type of business (see figure below).

Companies that have high inventory turnover and do business on a cash basis – usually have a low or negative CCC and hence needs very little working capital.

For companies that make investment products the situation is a completely different. As these types of businesses are selling expensive items on a long-term payment basis, they will tend to have a high CCC and must keep enough working capital on hand to get through any unforeseen difficulties.

The CCC cannot be directly observed in the cash flows, because these are also influenced by investment and financing activities and must be derived from the firm’s balance sheet:

+ Inventory conversion period (DSI)
+ Receivables conversion period (DSO)
– Payable conversion period (DPO)
= Cash Conversion Cycle (days)

Where:

DSI = Days sales of inventory, DSO = Days sales outstanding, DPO = Days payable outstanding, WIP = Work in progress, Period = Accounting period and COGS = Cost of goods sold ((COGS = Opening inventory + Purchase of goods – Closing inventory)) or:

+ Average inventory+WIP / [COGS/days in period]
+ Average Accounts Receivable / [Revenue / days in period]
+ Average Accounts Payable / [(Inventory increase + COGS)/ days in period]
= Cash Conversion Cycle (days)

The Observations

Even if not all of the working capital is determined by the cash conversion cycle, there should be a tendency for higher return on operating capital with lower CCC. However the data from the annual survey (Katz, 2010) does not support this ((Data used with permission from REL/CFO. Twenty of the one thousand observations have been removed as outliers, to give a better picture of the relation)):

The scatter graph shows no direct relation between return on operating capital and the cash conversion cycle. A closer inspection of the data for the surveys different industries confirms this.

Since the total amount of capital invested in the CCC is:

and is thus a function of sales. The company size will then certainly play a role when we only look at the yearly data. The survey however also gives the change from 2008 to 2009 for all the companies so we are able to remove the size effect by looking at the changes (%) in ROCE by a change in CCC:

The graph still shows no obvious relation between change (%) in CCC and change (%) in ROCE. Now, we know that the shorter this cycle, the fewer resources the company needs to lock-up; reduced debtor levels (DSO), decreased inventory levels (DSI) and/or increased creditor levels (DPO) must have an effect on the ROCE – but will it be lost in the clutter of all the other company operations effects on the ROCE?

Cash Management

Net operating working capital is the cash plus cash equivalents needed to pay for the day-to-day operation of the business. This will include; demand deposits, money market accounts, currency holdings and highly liquid short-term investments such as marketable securities ((Marketable securities with a maturity of less than three months are referred to as ‘cash equivalents’ on the balance sheet, those with a longer maturity as ‘short-term investments’)); portfolios of highly liquid, near-cash assets which serves as a backup to the cash account.

There are many reasons why holding cash is important; to act as a buffer when daily cash flows do not match cash out flows (Transaction motive), as a safety stock to face forecast errors and unforeseen expenses (Precautionary motive) or to be able to react immediately when opportunities can be taken (Speculative motive). If the cash level is too low and unexpected outflows occurs, the firm will have to either borrow funds or in the case of an investment – forgo the opportunity.

Such short-term borrowing of funds can be costly as can a lost opportunity by the lost returns of rejected investments. Holding cash however also induces opportunity costs due to loss of interest.

Cash management therefore aim at optimizing cash availability and interest income on any idle funds. Cash budgeting – as a part of the firm’s of short-term planning – constitutes the starting-point for all cash management activities as it represents the forecast of cash in- and outflows and therefore reflects the firm’s expected availability and need for cash.

Working Capital Strategy

We will in the following look closer at working capital management using balance simulation ((In the Monte Carlo simulation we have used 200 runs, as that was sufficient to give a good enough approximation of the distributions)). The data is from a company with large fixed assets in infrastructure. The demand for its services is highly seasonal as schematic depicted in the figure below:

A company like this will need a flexible working capital strategy with a low level of working capital in the off-seasons and high levels in the high seasons. As the company wants to maximize its equity value it is looking for working capital strategies that can do just that.

The company has been working on its cash conversion cycle, and succeeded in that with on average of only 11,1 days 1M (standard deviation 0,2 days) (across seasons) for turning supplied goods and services into cash:

All the same, even then a substantial amount, on average €4,1M (standard deviation €1,8M) of the company’s resources, is invested in the cash conversion cycle:

In addition the company needs a fair amount of cash to meet its other obligations. Its first strategy was to keep cash instead of using short term financing in the high seasons. In the off-seasons this strategy gives a large portfolio of marketable securities – giving a low return and thereby a low contribution to the ROCE. This strategy can be described as being close to the red line in the seasonal graph above.

When we now plot the two hundred observed (simulated) values of working capital and the corresponding ROE (from now we use return on equity (ROE) since this of more interest to the owners), we get a picture as below:

This lax strategy shows little relation between the amount of working capital and the ROE and – from just looking at the graph it would be easy to conclude that working capital management is a waste of time and effort.

Now we turn to a stricter strategy: keeping a low level of cash through all seasons, using short term financing in the high seasons and always have cash closely connected to expected sales. Again plotting the two hundred observed values we get the graph below:

From this graph we can clearly see that if we can reduce the working capital we will increase the ROE – even if we live in a stochastic environment. By removing some of the randomness in the amount of working capital by keeping it close to what is absolutely needed – we get a much clearer picture of the effect. This strategy is best described as being close to the green line in the seasonal graph.

Since we use pseudo-random ((Pseudo random number generator (PRNG), also known as a deterministic random bit generator, is an algorithm for generating a sequence of numbers that approximates the properties of random numbers. The sequence is not truly random in that it is completely determined by a set of initial values, called the seed number)) simulation we have replicated the first simulation (blue line), for the stricter strategy (green line).

This means that the same events happened for both strategies; changes in sale, prices, costs, interest and exchange rates etc. The effects for the amount of working capital are shown in the graph below:

The lax strategy (blue line) will have an average working capital of €4,8M with a standard deviation of €3.0M, while the strict strategy (green line) will have an average working capital of €1,4M with a standard deviation of €3.3M.

Even if the stricter strategy seems to associate lower amounts of working capital with higher return to equity (se figure) and that the amount of working capital always is lower than under the laxer strategy, we have not yet established that it is a better strategy.

To do this we need to simulate the strategies over a number of years and compare the differences in equity value under the two strategies. Doing this we get the probability distribution for difference in equity value as shown below:

The expected value of the strict strategy over the lax strategy is €3,4 M width a standard deviation of €6,1 M. The distribution is skewed to the right, so there is also a possible additional upside. From this we can conclude that the stricter strategy is stochastic dominant to the laxer strategy. However there might be other strategies that can prove to be better.

This brings us to the question: does an optimal working capital strategy exist? What we do know that there will be strategies that are stochastic dominant, but proving one to be optimal might be difficult. Given the uncertainty in any firm’s future operations, you will probably first have to establish a set of strategies that can be applied depending on the set of events that can be experienced by the firm.

References

Filbeck, G, Krueger, T, & Preece, D. (2007). Cfo magazine’s “working capital survey”: do selected firms work for shareholders?. Quarterly Journal of Business and Economics , (March), Retrieved from http://www.allbusiness.com/company-activities-management/financial/5846250-1.html

Katz, D.M.K. (2010). Working it out: The 2010 Working Capital Scorecard. CFO Magazine, June, Retrieved from http://www.cfo.com/article.cfm/14499542

Weston, J. & Copeland, T. (1986). Managerial finance, Eighth Edition, Hinsdale, The Dryden Press

Footnotes

18/10/2010
Working Capital and the Balance Sheet

This entry is part 2 of 3 in the series Working Capital

The conservation-of-value principle says that it doesn’t matter how you slice the financial pie with financial engineering, share repurchases, or acquisitions; only improving cash flows will create value. (Dobbs, Huyett & Koller, 2010).

The above, taken from “The CEO’s guide to corporate finance” will be our starting point and Occam’s razor the tool to simplify the balance sheet using the concept of working- and operating capital.

To get a better grasp of the firm’s real activities we will as well separate non-operating assets from operating assets – since it will be the last that defines the firm’s operations.

To find the amount of operating current assets we have to deduct the sum of minimum cash level, inventories and account receivables from total current assets. The difference between total- and operating current assets is assumed placed in excess marketable securities – and will not be included in the working capital.

Many firms have cash levels above and well beyond what is really needed as working capital, tying up capital that could have had better uses generating higher return than mere short-term placements.

The net working capital now found by deducting non-interest bearing current liabilities from operating current assets, will be the actual amount of working capital needed to safely run the firms operations – no more and no less.

By summing net property, plant and equipment and other operating fixed assets we find the total amount of fixed assets involved in the firm’s operations. This together with net working capital forms the firms operating assets, assets that will generate the cash flow and return on equity that the owners are expecting.

The non-operating part – excess marketable securities and non-operating investments – should be kept as small as possible, since this at best only will give an average market return. The rest of the above calculations give us the firm’s total liability and equity, which we will use to set up the firm’s ordinary balance sheet:

However, by introducing operating-, non-operating- and working capital we can get a clearer picture of the firm’s activities ((Used in yearly reports by Stora Enso, a large international Pulp & Paper company, noted on NASDAQ OMX in Stockholm and Helsinki.)):

The balance sheet’s bottom line has been reduced by the smallest value of operating current assets and non-interest bearing debt and the difference between them – the working capital – will be an asset or a liability depending on which of them that have the largest value:

The above calculations is an integral part of our balance simulation model and the report that can be produced for planning, strategy- and risk assessment from the simulation can be viewed her; report for the most likely outcome (Pdf, pp 32). However this report can be produced for every run in the simulation giving the opportunity to look at tail events that might arise, distorting expectations.

Simplicity is the ultimate sophistication. — Leonardo da Vinci

References

Dobbs, D, Huyett, H, & Koller, T. (2010). The ceo’s guide to corporate finance. McKinsey Quarterly, 4. Retrieved from http://www.mckinseyquarterly.com/home.aspx

Endnotes

01/12/2010
Working Capital Strategy Revisited
This entry is part 3 of 3 in the series Working Capital

Introduction

To link the posts on working capital and inventory management, we will look at a company with a complicated market structure, having sales and production in a large number of countries and with a wide variety of product lines. Added to this is a marked seasonality with high sales in the years two first quarters and much lower sales in the years two last quarters ((All data is from public records)).

All this puts a strain on the organizations production and distribution systems and of course on working capital.

Looking at the development of net working capital ((Net working capital = Total current assets – Total current liabilities)) relative to net sales it seems as the company in the later years have curbed the initial net working capital growth:

Just by inspecting the graph however it is difficult to determine if the company’s working capital management is good or lacking in performance. We therefore need to look in more detail at the working capital elements and compare them with industry ‘averages’ ((By their Standard Industrial Classification (SIC) )).

The industry averages can be found from the annual “REL Consultancy /CFO Working Capital Survey” that made its debut in 1997 in the CFO Magazine. We can thus use the survey’s findings to assess the company’s working capital performance ((Katz, M.K. (2010). Working it out: The 2010 Working Capital Scorecard. CFO Magazine, June, Retrieved from http://www.cfo.com/article.cfm/14499542
Also see: https://www.strategy-at-risk.com/2010/10/18/working-capital-strategy-2/)).

The company’s working capital management

Looking at the different elements of the company’s working capital, we find that:

I.   Day’s sales outstanding (DSO) is on average 70 days compared with REL’s reported industry median of 56 days.

II.   Day’s payables outstanding (DPO) is the difference small and in the right direction, 25 days against the industry median of 23 days.

III.   Day’s inventory outstanding (DIO) on average 138 days compared with the industry median of 23 days, and this is where the problem lies.

IV.   The company’s days of working capital (DWC = DSO+DIO-DPO) (( Days of working capital (DWC) is essentially the same as the Cash Conversion Cycle (CCC). Se endnote for more.)) have on average according to the above, been 183 days over the last five years compared to REL’s median DWC of 72 days in for comparable companies.

This company thus has more than 2.5 times ‘larger’ working capital than its industry average.

As levers of financial performance, none is more important than working capital. The viability of every business activity rests on daily changes in receivables, inventory, and payables.

The goal of the company is to minimize its ‘Days of Working Capital’ (DWC) or which is equivalent the ‘Cash Conversion Cycle’ (CCC), and thereby reduce the amount of outstanding working capital. This requires examining each component of DWC discussed above and taking actions to improve each element. To the extent this can be achieved without increasing costs or depressing sales, they should be carried out:

1.   A decrease in ‘Day’s sales outstanding’ (DSO) or in ‘Day’s inventory outstanding’ (DIO) will represent an improvement, and an increase will indicate deterioration,

2.   An increase in ‘Day’s payables outstanding’ (DPO) will represent an improvement and an decrease will indicate deterioration,

3.   Reducing ‘Days of Working Capital’ (DWC or CCC) will represent an improvement, whereas an increasing (DWC or CCC) will represent deterioration.

Day’s sales- and payables outstanding

Many companies think in terms of “collecting as fast as possible, and paying as slowly as permissible.” This strategy, however, may not be the wisest.
At the same time the company is attempting to integrate with its customers – and realize the related benefits – so are its suppliers. A “pay slow” approach may not optimize either the accounts or inventory, and it is likely to interfere with good supplier relationships.

Supply-chain finance

One way around this might be ‘Supply Chain Finance ‘(SCF) or reverse factoring ((“The reverse factoring method, still rare, is similar to the factoring insofar as it involves three actors: the ordering party, the supplier and the factor. Just as basic factoring, the aim of the process is to finance the supplier’s receivables by a financier (the factor), so the supplier can cash in the money for what he sold immediately (minus an interest the factor deducts to finance the advance of money).” http://en.wikipedia.org/wiki/Reverse_factoring)). Properly done, it can enable a company to leverage credit to increase the efficiency of its working capital and at the same time enhance its relationships with suppliers. The company can extend payment terms and the supplier receives advance payments discounted at rates considerably lower than their normal funding margins. The lender (factor), in turn, gets the benefit of a margin higher than the risk profile commands.

This is thus a form of receivables financing using solutions that provide working capital to suppliers and/or buyers within any part of a supply chain and that is typically arranged on the credit risk of a large corporate within that supply chain.

Day’s inventory outstanding (DIO)

DIO is a financial and operational measure, which expresses the value of inventory in days of cost of goods sold. It represents how much inventory an organization has tied up across its supply chain or more simply – how long it takes to convert inventory into sales. This measure can be aggregated for all inventories or broken down into days of raw material, work in progress and finished goods. This measure should normally be produced monthly.

By using the industry typical ‘days inventory outstanding’ (DIO) we can calculate the potential reduction in the company’s inventory – if the company should succeed in being as good in inventory management as its peers.

If the industry’s typical DIO value is applicable, then there should be a potential for a 60 % reduction in the company’s inventory.

Even if this overstates the true potential it is obvious that a fairly large reduction is possible since 98% of the 1000 companies in the REL report have a value for DIO less than 138 days:

Adding to the company’s concern should also be the fact that the inventories seems to increase at a faster pace than net sales:

Inventory Management

Successfully addressing the challenge of reducing inventory requires an understanding of why inventory is held and where it builds in the system.
Achieving this goal requires a focus on inventory improvement efforts on four core areas:
1. demand management – information integration with both suppliers and customers,
2. inventory optimization – using statistical/finance tools to monitor and set inventory levels,
3. transportation and logistics – lead time length and variability and
4. supply chain planning and execution – coordinating planning throughout the chain from inbound to internal processing to outbound.
We believe that the best way of attacking this problems is to produce a simulation model that can ‘mimic’ the sales – distribution – production chain in necessary detail to study different strategies and the probabilities of stock-out and possible stock-out costs compared with the costs of doing the different products (items).

The costs of never experience a stock-out can be excessively high – the global average of retail out-of-stocks is 8.3% ((Gruen, Thomas W. and Daniel Corsten (2008), A Comprehensive Guide to Retail Out-of-Stock Reduction in the Fast-Moving Consumer Goods Industry, Grocery Manufacturers of America, Washington, DC, ISBN: 978-3-905613-04-9)) .

By basing the model on activity-based costing, it can estimate the cost and revenue elements of the product lines thus either identify and/or eliminate those products and services that are unprofitable or ineffective. The scope is to release more working capital by lowering values of inventories and streamlining the end to end value chain

To do this we have to make improved forecasts of sales and a breakdown of risk and economic values both geographically and for product groups to find out were capital should be employed coming years (product – geography) both for M&A and organic growth investments.

A model like the one we propose needs detailed monthly data usually found in the internal accounts. This data will be used to statistically determine the relationships between the cost variables describing the different value chains. In addition will overhead from different company levels (geographical) have to be distributed both on products and on the distribution chains.

Endnote

Days Sales Outstanding (DSO) = AR/(total revenue/365)

Year-end trade receivables net of allowance for doubtful accounts, plus financial receivables, divided by one day of average revenue.

Days Inventory Outstanding (DIO) = Inventory/(total revenue/365)

Year-end inventory plus LIFO reserve divided by one day of average revenue.

Days Payables Outstanding (DPO) = AP/(total revenue/365)

Year-end trade payables divided by one day of average revenue.

Days Working Capital (DWC): (AR + inventory – AP)/(total revenue/365)

Where:
AR = Average accounts receivable
AP = Average accounts payable
Inventory = Average inventory + Work in progress

Year-end net working capital (trade receivables plus inventory, minus AP) divided by one day of average revenue. (DWC = DSO+DIO-DPO).

For the comparable industry we find an average of: DWC=56+39-23=72 days

Days of working capital (DWC) is essentially the same as the Cash Conversion Cycle (CCC) except that the CCC uses the Cost of Goods Sold (COGS) when calculating both the Days Inventory Outstanding (DIO) and the Days Payables Outstanding (DPO) whereas DWC uses sales (Total Revenue) for all calculations:

CCC= Days in period x {(Average inventory/COGS) + (Average receivables / Revenue) – (Average payables/[COGS + Change in Inventory)]

Where:
COGS= Production Cost – Change in Inventory

Footnotes
27/11/2012