Where We Left…
In our three-part series on Mastering Your Working Capital, we explored different perspectives on evaluating and optimising the working capital in a firm.
The first article, examined how Net Working Capital (NWC) offers a snapshot of a firm’s financial position at a specific point in time. This metric reveals how much working capital is available and is often paired with the current and quick ratios, which provide simple and intuitive measures of financial health. Additionally, we introduced a NWC calculator tailored for public companies in Belgium.
In the second article, we delved into the Cash Conversion Cycle (CCC), which helps businesses measure how long their working capital is tied up in operations before generating a return. This metric depicts the time between paying for resources and receiving returns. Additionally, the CCC forms a component of calculating the opportunity cost of investing capital into your business.
In the third article, we focused on the Weighted Average Cost of Capital (WACC), a key metric for determining the minimum required return on investments and evaluating future opportunities. Through a concrete example, we demonstrated how strategic use of funds can transform an investment with a negative NPV into one with a positive outcome.
While these metrics provide valuable tools, mastering your working capital requires addressing some yet to be discussed elements—managing the cost of capital and determining the need for working capital.
Key Take-aways
- Managing working capital effectively requires understanding how the metrics interconnect with each other.
- Optimising the CCC and WCR minimises the reliance on external financing, lowering the overall cost of capital.
- Combining strategic decisions with operational optimalisation ensures a firm’s working capital is not just managed but mastered.
Managing the Cost of Capital: Strategic and Operational Perspectives
Effectively managing the cost of capital requires a combination of strategic and operational approaches. On a strategic level, businesses should focus on optimising their capital structure, i.e balancing debt and equity, managing risk, and ensuring sustainable growth. Operationally, however, the cost of capital is heavily influenced by how efficiently a business uses its working capital. This is where the Cash Conversion Cycle (CCC) becomes a powerful tool.
Strategic Influences on the Cost of Capital
A closer look at the components of the Weighted Average Cost of Capital (WACC) reveals several factors that are directly impacted by a firm’s strategic decisions. Here’s a summary:
- Capital Structure: The capital structure refers to the mix of debt and equity a firm maintains. This is one of the primary responsibilities of a CFO and requires balancing risk and value creation. The choice of financing mix involves trade-offs and costs, as firms must manage a variety of stakeholders, including lenders, creditors, and shareholders. Strategic decisions here can have far-reaching implications for a firm’s financial health.
- Cost of Debt: first share of the metaphorical pie is pretty straightforward as the details in Terms and Conditions clearly dictate the associated costs from lending capital. Lenders usually have considerable guarantees as they can claim the crown jewels of the firm.
- Cost of Equity: Determining the cost of equity, however, is far more complex. The go-to model for this is the Capital Asset Pricing Model (CAPM), which considers the level of systematic risk (bèta) and expected return, as defined by the Security Market Line. The CAPM is not without criticism, particularly from the field of Behavioral Economics.
Critics argue that decision-makers often fail to fully understand all the risks involved due to cognitive biases. For instance:
- Prospect Theory highlights how decision-makers tend to overweigh potential losses compared to equivalent gains.
- Political decision-making can lead to uncritical adoption of proposed financial theories.
- Investor overconfidence has been shown to impact industries both positively and negatively.
Proven strategies include evaluating multiple scenarios by varying factors to assess their impact on the investment. Additionally, seeking an outsider’s perspective can help identify potential blind spots and provide a more objective evaluation of the associated risks and opportunities.
Operational Influences on the Cost of Capital
When examining operational influences on the cost of capital, the Cash Conversion Cycle (CCC) is an essential metric. In our previous article on the CCC, we introduced its components —Days Sales Outstanding (DSO), Days Inventory Outstanding (DIO), and Days Payable Outstanding (DPO)—and briefly discussed the factors influencing each. These components provide several opportunities for optimisation, allowing firms to reduce the time their working capital is tied up in operations. While we will delve deeper into these components in future articles, a general assessment can be made using Porter’s Five Forces.
Days Sales Outstanding (DSO)
DSO is directly linked to the bargaining power of buyers, encompassing both price negotiations and Terms & Conditions of sales. For example, a potential buyer not only evaluates the price of a product or service but also considers the payment terms, such as credit availability. Firms must carefully assess whether offering credit is worth the potential trade-offs, such as:
- Higher administrative costs for maintaining a credit system.
- Increased sales opportunities due to credit availability.
- Potential losses from bad debt or delayed payments.
Optimising DSO requires balancing these factors to minimise risks while maximising benefits.
Days Payables Outstanding (DPO)
DPO depends on a firm’s bargaining power with suppliers. While aggressive tactics to pressure suppliers for longer payment terms may produce short-term gains, sustainable relationships are built on mutual respect and cooperation. A win-win approach often proves more beneficial, as firms and suppliers usually depend on each other’s success. Strategic negotiation skills are key to achieving favourable terms while maintaining strong supplier relationships.
This makes robust working capital management essential for businesses aiming to scale. A well-managed balance sheet not only bolsters ratings but also opens doors to growth opportunities.
*CFOrent-tip*: The dance of DSO & DPO.
One firm’s DSO is another firm’s DPO. In theory, they should align perfectly: Firm A’s DSO begins the day the invoice is issued, but in practice, it starts earlier, when they deliver their services or ship their goods. On the other side, Firm B’s DPO begins when they can utilise the goods or services they’ve received. There’s usually a void present. For firm A, extra DSO is not favourable while for firm B, extra DPO usually comes in handy.
So, why does this matter? Start-ups and scale-ups are particularly vulnerable to the (often automated) ratings assigned by credit providers, rating agencies, and insurance companies. These ratings are typically assessed based on end-of-year balance sheets, where even a €100,000 difference can significantly affect a company’s rating—and, by extension, its growth potential.
Locating and closing these voids as tight as possible is done with good WCM!
Days Inventory Outstanding (DIO)
Reducing DIO involves addressing industry rivalry, which influences everything from pricing strategies to operational efficiency. Internally, firms can optimise DIO by improving warehouse efficiency or implementing inventory management strategies. For example:
- Production/Warehouse automatisation can significantly enhance efficiency, as seen at the Mercedes factory in Sindelfingen, Germany, with an estimated lead time of three days. Start to finish.
- Smaller-scale improvements, such as adopting inventory models like Economic Order Quantity (EOQ) or Just-In-Time (JIT) systems, can also yield substantial results.
- Strategic supplier selection can further reduce inventory costs and improve turnover.
By addressing these three components of the CCC, firms can improve operational efficiency, reduce opportunity costs, and directly influence their overall cost of capital.
While strategic decisions lay the groundwork for managing the cost of capital, operational efficiency determines how effectively that capital is used in practice. This is where the Cash Conversion Cycle becomes a valuable tool.
Determine Need for Working Capital with WCR
Working Capital Requirement (WCR) provides insight on how much working capital your firm needs to maintain liquidity and ensure its operations. Together, these metrics offer a comprehensive view of working capital management, providing both a time measure, CCC, and a size measure, WCR.
In the article about Net Working Capital, we stated that “Net Working Capital (NWC) is a key metric that assesses a company’s liquidity and operational efficiency by evaluating its short-term assets and liabilities.”
- Liquidity Management: WCR ensures that the firm has enough current assets to cover current liabilities. Insufficient liquidity can lead to cash flow crises, while excess liquidity signals inefficiencies.
- Operational Efficiency: The CCC will reveal whether capital is tied up in receivables or inventory for too long, limiting funds available for growth or investment. Using the CCC in WCR determines whether inefficiencies are present in a firm.
Effective management is the sauce that makes it all stick. Successful practices in WCR are based on sales forecasting and pro forma balance sheet statements. But working capital management is only as good as the assumptions that underlie the evaluations by the firm. The old cliché of “Garbage In, Garbage Out” applies in this case.
- Cost of Capital Implications: Arguably one of the worst losses would be having to loan money, when it would be available in a firm but it is poorly managed. A poorly managed WCR increases reliance on short-term financing which can raise the overall cost of capital.
- Strategic Connection: WCR directly affects a firm’s capital structure decisions. Bringing us back to the earlier discussed influence of capital structure and directly influencing the WACC.
- Operational Connection: WCR management complements CCC optimisation by addressing the broader financial health of the firm.
- Negotiating better payment terms with suppliers will lower WCR.
- Implementing efficient inventory management strategies, such as JIT or EOQ, can reduce excess stock and lower WCR.
By understanding how these metrics interact, firms can align their operational decisions with strategic goals, ensuring that capital is both effectively utilised and efficiently managed. As we conclude this series, it’s clear that these metrics do not stand alone, instead, they function as an integrated framework. Together, they enable firms to identify opportunities, mitigate risks, and achieve long-term financial success.
Give It a GO!
An additional CFOrent-tip for this article is wrapped in the spirit of the PDCA-cycle:
- Plan: Plan is in some cases preceded by the term Observe. Visualising your financial data—through reports, dashboards, or charts—helps assess your firm’s current state. Regular reviews (weekly, monthly, or quarterly) can highlight deficiencies or opportunities for optimisation. Low-hanging fruit can be acted upon relatively quickly while long term evalutions will allow you to strategise for bigger interventions.
- Do: Once you’ve identified actionable areas, it’s up to executive management to implement changes within the relevant departments. This could include adjustments in credit control, purchasing, or other operational areas. Clear communication and alignment across departments are key to successful execution.
- Check: Dashboards are essential tools for monitoring progress and gaining valuable insights. They empower both management and employees to understand how daily operations impact broader business goals. Combine this step with the philosophy of Kaizen (continuous improvement) by sharing the responsibility of monitoring and improvement with all participants in the company.
- Act/Adjust: Successful change doesn’t end with implementation—it requires fine-tuning processes and fostering a culture that embraces adaptation. Key elements for success include:
- Clear delegation of responsibilities to ensure adjustments are made efficiently.
- Implementing organisational alignment, knowledge management and skill matrices to support rapid, effective responses.
The ability to adapt quickly without burdening the executive branch with unnecessary decision-making can be the defining factor in your company’s success.
Conclusion
At CFOrent, we hope our three-part series on Mastering Your Working Capital has provided valuable insights into the importance of Working Capital Management. With this addendum, we aimed to bring the topics full circle, demonstrating how Net Working Capital, Cash Conversion Cycle, and Weighted Average Cost of Capital are interconnected. These concepts rarely stand alone—they work together to form the foundation of effective financial management.
If your business is facing challenges in optimising working capital, reducing costs, or improving financial performance, our experts at CFOrent are here to help. Get in touch to discuss tailored solutions for your business needs.
