Working Capital (#211)
/In this podcast episode, we discuss working capital - what it is, how it works, and how to manage it. Key points made are noted below.
The Nature of Working Capital
Working capital is current assets minus current liabilities. More specifically, it’s usually considered to be just accounts receivable, inventory, and accounts payable.
The main point with working capital is that it can use up a lot of cash. Of those three components, accounts receivable uses cash, inventory uses cash, and accounts payable is a source of cash. When you combine the three, this usually means that working capital uses cash, because the amount of payables is far less than the amount of the other two.
When you look at the financial reasons for why a business fails, profitability is first, but the burden imposed by needing too much working capital probably ranks second. So if a business requires too much working capital, it consumes all available cash, to the point where you can’t pay suppliers or employees on time, and the business collapses.
Management of Payables
So how do we manage working capital? I’ll start with the accounts payable component. This is a source of cash, and that’s because suppliers are essentially extending you an interest-free loan. When a business starts up, it probably won’t be able to convince many suppliers to give it credit, so it won’t have the benefit of this loan. Once the company has some history behind it, suppliers will start extending credit. Do not abuse the credit and pay late, since they’ll just cut off your credit, and then you have to pay up front - and there goes the free loan. It seems as though everyone abuses their suppliers by stretching out their payments. This is a bad idea, since accounts payable has the best loan terms you’ll ever see.
Management of Receivables
Then we have receivables. This one can kill a growing company, because managers are always willing to extend credit in order to increase sales. What they never seem to comprehend is that this requires an infusion of cash to keep the company running while waiting for customers to pay their bills. So, the faster a company grows, the more working capital it needs. This is a particular problem when the margin on the goods sold is really thin.
The Impact of Gross Margins
In this case, the company has to pay for a large amount of cost of goods sold, while waiting to be paid. Conversely, if a business has really high gross margins, it’s not actually expending that much cash to pay for its products, so it requires less cash to fund the receivables. What this means is that a company with really low margins doesn’t have the cash to grow rapidly, whereas a company with really high margins can grow fast without needing that much cash to do so.
This issue can be spotted up front, during the business planning stages. If you know that margins will be low, then don’t plan for rapid sales growth. The company will just go bankrupt. And don’t think you can get around the problem by taking on lots of debt, because the interest cost will soak up all of the residual cash.
The Use of Factoring
The only case when you can legitimately take on debt to fund working capital needs is when the margins are really high. In this case, selling the receivables through a factoring arrangement will inject cash straight into the business, so it’s possible to keep growing at a rapid pace. An even though the interest expense is high, the margins are high enough to support the payments.
Shifting to New Market Niches
Another issue related to receivables is that a company presumably starts off by selling into the most profitable market niche it can find. The profits will probably support a reasonable amount of working capital. But at some point, the market niche has been fully addressed, and there aren’t any more sales to be gained in that area. So the management team decides to go after the next most profitable market niche. So the margins are a bit lower, which means that there’s less cash available to fund the related receivables. And this goes on as management keeps addressing less and less profitable niches. The end result is that working capital increases faster than sales, which creates a financing problem.
Changes to Credit Terms
A major problem arises when a customer wants to extend its credit terms, or management wants to sell to less financially stable customers that are less likely to pay on time. In either case, the company is essentially extending an even longer-term interest-free loan to its customers, and that really increases the investment in working capital. Unless the business is unusually well funded, it doesn’t make much sense to get into these arrangements.
Management of Inventory
And then we have the third component of working capital, which is inventory. This is another company killer. In fact, it’s potentially a worse company killer than receivables, because at least there’s a collections team in charge of collecting receivables. There’s no such team for inventory. Instead, the inventory investment keeps piling up at a rate faster than the sales growth rate. There’re a lot of reasons for it. For example, the purchasing department decides to buy a pile of raw materials because it can take advantage of a volume discount, and some of the materials are never used. Or, a product is discontinued before all of its components have been used up, so the components become obsolete. Or, customer demand drops, which leaves a bunch of finished goods rotting in the warehouse. And to make matters worse, converting excess inventory into cash usually involves taking a large discount from the original purchase price, so sometimes managers had rather keep the inventory than sell it and book a loss. All of these factors mean that the inventory investment tends to increase at least as fast as sales, if not more so.
Managing inventory is a tough proposition. The best bet is to never let inventory pile up in the first place, which means producing only when there’s a specific customer order to support it. At a minimum, invest in a material requirements planning system, which imposes a lot of control over the purchasing and use of inventory.
The Impact of Declining Sales
And finally, there’s the odd situation where the need for working capital has forced the owners to shut it down or at least scale back operations. A funny thing happens then. As sales decline, the cash balance shoots up – really fast. The reason is that inventory is being sold off and receivables are being collected, and there’s no need to replace them. Instead, the inventory is converted into receivables, and the receivables become cash. And when everything is done, the owners will be sitting on a pile of cash and wondering why their business failed.
The reason it failed was that they didn’t pay attention to the level of working capital required when they decided to grow sales. In short, you have to be aware of working capital when you plan a business, and understand how each individual business decision can impact the investment in working capital.