9d ago in Private Equity
Working Capital Series: Measuring And Monitoring
Working capital is a key element in understanding and enhancing free cash flow, which is why it is a priority for businesses aiming to optimize financial performance. To improve working capital, it’s essential first to understand how to measure and keep track of it. Consistent measurement allows evaluation of the success of initiatives and potentially uncovers ways to generate more cash from existing earnings.
What Exactly Is Measured?
The primary focus is on working capital absorption, which refers to the amount of cash tied up in working capital. Ideally, this figure should be negative, indicating cash surplus, while complete absorption suggests all cash is tied up, signaling financial distress. A commonly used metric for measuring this is the ratio of working capital to sales (WC/Sales), which indicates the proportion of sales revenue not yet realized as cash.
Why Use WC/Sales?
WC/Sales is favored for its simplicity and adaptability. It provides insights even as a company scales, helping monitor changes in working capital alongside growth. While an increase in company size could lead to improved metrics due to better customer and supplier leverage, it could also deteriorate if growth relies on less stringent credit practices. Monitoring WC/Sales frequently, such as weekly or daily, helps detect trends over time.
Detailed Day Measures For a deeper analysis, day measurements like debtor days, creditor days, and inventory days are used. These are essentially ratios expressed as turnover periods. Debtor days, for instance, are calculated by dividing debtors by sales and multiplying by the number of days in the year, showing the average time it takes for debtors to pay. Similarly, creditor and inventory day calculations use COGS instead of sales, demonstrating how often inventory turns over in a year or how long it takes to pay suppliers.
Integrated Monitoring Approach Combining WC/Sales with debtor, creditor, and inventory days provides a comprehensive view. If WC/Sales rises, examining day measures can help pinpoint the primary cause, allowing targeted management intervention. In some cases, external factors like market changes might affect a driver, prompting the need to focus on a different area to balance the overall metric.
Frequent Monitoring Is Essential Given that working capital can fluctuate significantly due to single payments or shipments, regular tracking is vital. For rapidly expanding businesses, poor management can quickly lead to severe financial issues. Regular, detailed monitoring helps catch these changes early, safeguarding against potential disruptions.
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Working Capital Series: Measuring And Monitoring
