Working Capital Management: What Data Matters?

This is done to bolster cash flow, meet short-term goals and maintain liquidity. 

As a starting point, organizations use the following formula to calculate their working capital: current assets minus current liabilities = working capital.

Current assets are defined as everything that can be turned into cash in the next 12 months. This could be cash in hand, short-term inventory and accounts receivables. Meanwhile, current liabilities are anything that must be paid off in the next 12 months. This may include accounts payables and debt payments. 

Then you need to determine the essential types of working capital, which cover:

• Gross working capital: The complete value of a company’s current assets and involves calculating the difference between existing assets and current liabilities. The difference is the actual working capital that a company has available.

• Net working capital: This is the difference between current assets and current liabilities. If the former is more than the latter, then it means there’s positive working capital and a company can meet its obligations. The opposite means that an organization is struggling financially.

• Regular working capital: This is the day-to-day money that businesses need to operate (i.e. staff wages and raw materials).

• Permanent working capital: This is the minimum amount of capital needed to keep the lights on. 

• Reserve margin working capital: This is any cash that is saved as a buffer against unforeseen circumstances (i.e. labor shortages and recession). 

• Variable working capital: This is capital invested in the business for a temporary amount of time and covers seasonable and special. The first is the capital kept aside to meet seasonal demand, while the second is a temporary increase due to any special circumstances. 

Now that you understand the different types of working capital, let’s turn our attention towards data points. Because there are specific data points that are essential for managing working capital effectively. We’ll also look at some potential green flag and red flag scenarios so you’re aware of what to look out for. 

DSO measures how quickly a company collects payment from its customers after making a sale. It’s calculated by dividing accounts receivable by average daily sales. The results represent the average number of days it takes for a company to collect payment after a sale. A lower DSO indicates efficient collections, which helps in maintaining a healthy cash flow. Bear in mind that different industries will have varying DSO scores. For example, the financial industry would typically have a longer payment period than the agricultural industry. 

When DSO is a green flag

DSO is decreasing over time, indicating that a company is improving its collections process. The DSO score is generally 45 or less and takes into consideration factors like industry, specific payment terms like Net 30 or Net 60 and how a company ranks against competitors.

Also, if the DSO is lower than the industry benchmark this is another good sign. It suggests efficient credit management. 

When DSO is a red flag 

DSO is increasing steadily, indicating a potential problem with collecting receivables promptly. Or it’s significantly higher than the industry average, highlighting issues with credit policies and customer payment behavior. 

DIO measures how long it takes for a company to convert its inventory into sales. It’s calculated by dividing the average inventory by the average daily cost of goods sold. The result represents the average number of days it takes for a company to sell its inventory. A lower DIO suggests efficient inventory management, which helps in minimizing holding costs and improving cash flow.

When DIO is a green flag

DIO is decreasing, indicating that the company is selling inventory more efficiently. This means working capital can be used more efficiently and put towards other things like paying off debt. There’s also less chance of inventory being written off.

When DIO is a red flag

A high DIO means a company isn’t converting inventory into sales fast enough. This could indicate deeper problems with inventory management and overstocking. In this scenario, there’s an increase in storage costs and working capital being tied into that management. 

This metric measures how long a company takes to pay suppliers. It’s calculated by dividing accounts payable by the average daily cost of goods sold. The result represents the average number of days it takes for a company to pay its suppliers. A higher DPO indicates that the company is taking longer to pay its bills, which can free up cash for other uses.

When DPO is a green flag

DPO is increasing, suggesting that a company is taking longer to pay its suppliers. Or it’s in line with or higher than the sector benchmark, indicating effective supplier relationship management. Amazon is a great case study here - its DPO score in 2022 was 100 days. What this means is Amazon leveraged its size to be in open-period contracts where it didn’t need to pay invoices. 

Whole Foods is another green flag example. We found in our data that it paid only 8% of invoices late to suppliers and had a healthy credit score of 80. It also used its large size to extend the length of payment terms to optimize its working capital for better financial health. 

When DPO is a red flag

When DPO is decreasing, that potentially shows financial distress or strained relationships with suppliers. Another scenario is when it’s significantly lower than the industry average. The organization potentially isn’t making the most of supplier credit terms.

A red flag story comes with Revlon, which managed to overcome bankruptcy in May 2023 after lots of controversy and debt. But while in the middle of all the chaos, we found Revlon paid 41% of supplier invoices late. So, it was little wonder the company struggled. 

This ratio measures how many times a company's inventory is sold and replaced over a period. A higher turnover indicates efficient inventory management and can lead to lower holding costs. And the calculation involves dividing the cost of goods sold by the average inventory. This shows a representation of how many times the inventory is sold and replaced within a given period.

When ITO is a green flag

The ITO is high, usually between 5 - 10. This demonstrates a business is turning inventory over every 1 - 2 months but may vary depending on industry. For instance, with a grocer that sells perishable goods, the ITO may be higher to stop inventory from being lost due to spoilage. 

When ITO is a red flag

The inventory ratio is low, suggesting inventory isn’t moving fast enough and there’s an overstocking problem. Or perhaps there’s not enough focus on marketing or there’s pricing issues. Competitors are offering goods at a lower price and have invested more in their marketing strategies. 

The working capital cycle represents the time it takes for a company to convert its investments in raw materials and finished goods back into cash. This formula works by determining how long it takes to sell the inventory + how long it takes to receive payment - how long the time is to pay the supplier.

When working capital cycle is a green flag

Let’s take a look at an example of a good capital working cycle:

42 Inventory Days + 3 Receivables Days - 60 Payable Days = - 15 Working Capital Cycle. 

This - 15 is a good number because it shows the business is striving to improve cash flow. They are trying to move inventory quicker and may be lengthening payment terms. 

When working capital cycle is a red flag

The working capital cycle is increasing, potentially signaling inefficiencies in cash conversion cycles. And if the cycle is higher than the industry average this could point towards liquidity issues. 

Inventory cycle focuses specifically on the time it takes for a company to convert inventory into sales. This is crucial for optimizing inventory levels and avoiding stockouts or excess holding costs. 

And like other data points, the context changes based on sector. For a manufacturer, the cycle time would be measured by the rate of production. While for retailers, it’s a measurement of the speed of inventory being sold.

When inventory cycle is a green flag

Inventory cycle is short, meaning there’s an effective conversion of inventory into sales. An example of this effectiveness is a retailer using the ABC style of inventory cycle management. A accounts for high-profit margin and sales volume products with 80% revenue and 20% of total inventory. B is average to high-value products with 15% revenue to 10% of inventory. C is low-value and demand items accounting for 5% of revenue and 70% of total inventory. Using this approach leads to better accuracy and cash flow.

When inventory cycle is a red flag

The Inventory cycle is long and is above the industry average. This indicates that items aren’t being sold fast enough, demand isn’t high and there’s a lack of overall sales strategy. 

The AR cycle measures the time it takes for a company to collect payment from its customers. It's crucial for maintaining a healthy cash flow and managing credit policies effectively. Similar to DSO, it represents the average number of days it takes for a company to collect payment after a sale.

When AR cycle is a green flag

A strong AR cycle varies from industry to industry. Generally, companies should aim for a ratio of 1.0 so they’re able to collect the full amount of average accounts receivables at a minimum of one time per quarter. It’s better for an AR cycle to be short because it shows a swift collection of receivables. 

When AR cycle is a red flag

A bad AR cycle is long and you can also look to Days Beyond Terms (DBT) as an indicator here. If the DBT is 10+ then there’s likely some financial stress going on in the business. 

By monitoring and analyzing these data points, a company can gain insights into the efficiency of its working capital management. It allows for timely adjustments and improvements to ensure that the company maintains a healthy cash flow while effectively managing its assets and liabilities.

The working capital management process should never be managed alone. It’s a team effort, linked by the CFO and finance team liaising with procurement, sales and marketing. Each department should have visibility into the data points mentioned. Otherwise, there are several problems that will happen.

Our Enterprise Sales Director, Bill James, explained some of the most important problems to watch out for. These include:

• “Overstocking: Ineffective inventory management can lead to either excessive holding of inventory or insufficient stock to meet customer demand (stockouts). Lack of accurate demand forecasting, poor supplier communication, or inadequate inventory control systems can contribute to these issues.

• Inadequate credit policies: Offering lenient credit terms without proper assessment of customer creditworthiness can lead to an increased risk of bad debt and delayed payments. Failing to conduct thorough credit checks or not having clear credit policies in place can result in financial instability.

• Delayed collections: Inefficient accounts receivable management can lead to delayed collections from customers, affecting cash flow and liquidity. Inadequate follow-up on overdue payments, reactive approach vs proactive, unclear payment terms, or lack of a structured credit control process can contribute to this issue.

•  Late payments to suppliers: Delayed payments to suppliers can strain supplier relationships, potentially leading to strained credit terms or disruption in the supply chain. Poor communication with suppliers, inadequate cash flow forecasting, or lack of negotiation skills can contribute to late payments.

• Inefficient cash flow forecasting: Inaccurate or inadequate cash flow forecasting can lead to cash shortages or excess cash that is not optimized. Insufficient data analysis, failure to consider seasonality, or neglecting to account for unforeseen events can result in flawed cash flow forecasts.

• Ineffective use of short-term financing: Over-reliance on short-term financing options without a clear repayment plan can lead to a cycle of debt and financial instability. Failing to properly assess the cost and risks associated with short-term financing options, and not having a repayment strategy in place, can contribute to this issue.

•  Neglecting technology and automation: Failing to utilize technology and automation tools can result in manual errors, inefficient processes, and delayed decision-making.”