Working capital Strategies


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Working capital Strategies.
Strategic Risk and Performance management by Strategy@Risk Ltd.

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Working capital Strategies

  1. 1. See All Posts by S@RWorking Capital Strategy2010 • Related • Filed Under Passion is inversely proportional to the amount of real information available. See Benford’s law of controversy.The annual “REL1 /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 financialexecutives in the 21st century (Filbeck, Krueger, & Preece, 2007).The 2010 Working Capital scorecard (Katz, 2010) and its accompanying data2 gives us anopportunity to look at working capital management3; that is the effect of working capitalmanagement on the return on capital employed (ROCE): or,From the last formula we can see that – all else kept constant – a reduction in net operatingworking capital should imply an increased return on capital employed.Gross and Net Operating Working CapitalA firm’s gross working capital comprises its total current assets. One part of it will consist offinancial current assets held for various reasons other than operational, and the other part ofreceivables from operations and the inventory and cash necessary to run these operations. It isthis last part that interests us.The firm’s operations will have been long term financed by equity from owners and by loansfrom 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 thecurrent liabilities; current tax and dividends will not be considered as parts of operating currentliabilities, since they comprises only non recurrent payments.Net working capital is defined as the difference between current assets and current liabilities (seefigure below). It can be both positive and negative depending on the firm’s strategic position inthe market.  1
  2. 2. However usually a positive net working capital is required to ensure that the firm is able tocontinue its operations and that it has sufficient funds to satisfy both maturing short-term debtand upcoming operational expenses. In the following we assume that any positive net workingcapital 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 andnecessary for the operations, we arrive at net operating working capital as the difference betweenoperating current assets and operating current liabilities:Net operating working capital = Operating current assets – Operating current liabilitiesSince the needed amount of working capital will differ between industries and be dependent oncompany size it will be easier to base comparisons on the cash conversion cycle.Working Capital ManagementWorking 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 ofcash, inventory and accounts receivable. Therefore, working capital management will reflect thefirm’s short-term financial performance.  2
  3. 3. Current assets often account for more than half of a company’s total assets and hence, represent amajor investment for small firms as they can not be avoided in the same way as investments infixed assets can – by renting or leasing. A large inventory will tie up capital but it prevents thecompany from lost sales or production stoppages due to stock-out. A high level of current assetshence means less risk to the company but also lower earnings due to higher capital tie-up – therisk-return tradeoffs (Weston & Copeland, 1986).Since the needed amount of working capital will differ between industries and also will bedependent on company size it will be easier to base comparisons of working capital managementbetween companies and industries on their cash conversion cycle (CCC).The Cash Conversion CycleThe term “cash conversion cycle” (CCC) refers to the time span between a firm’s disbursing andcollecting cash and will thus be ‘unrelated’ to the firm’s size, but be dependent on the firm’s typeof business (see figure below).Companies that have high inventory turnover and do business on a cash basis – usually have alow or negative CCC and hence needs very little working capital.For companies that make investment products the situation is a completely different. As thesetypes of businesses are selling expensive items on a long-term payment basis, they will tend tohave a high CCC and must keep enough working capital on hand to get through any unforeseendifficulties.The CCC cannot be directly observed in the cash flows, because these are also influenced byinvestment 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 payableoutstanding, WIP = Work in progress, Period = Accounting period and COGS = Cost of goodssold4 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)  3
  4. 4. The ObservationsEven if not all of the working capital is determined by the cash conversion cycle, there should bea tendency for higher return on operating capital with lower CCC. However the data from theannual survey (Katz, 2010) does not support this5:The scatter graph shows no direct relation between return on operating capital and the cashconversion cycle. A closer inspection of the data for the surveys different industries confirmsthis.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 onlylook at the yearly data. The survey however also gives the change from 2008 to 2009 for all the  4
  5. 5. companies so we are able to remove the size effect by looking at the changes (%) in ROCE by achange in CCC:The graph still shows no obvious relation between change (%) in CCC and change (%) inROCE. Now, we know that the shorter this cycle, the fewer resources the company needs tolock-up; reduced debtor levels (DSO), decreased inventory levels (DSI) and/or increased creditorlevels (DPO) must have an effect on the ROCE – but will it be lost in the clutter of all the othercompany operations effects on the ROCE?Cash ManagementNet operating working capital is the cash plus cash equivalents needed to pay for the day-to-dayoperation of the business. This will include; demand deposits, money market accounts, currencyholdings and highly liquid short-term investments such as marketable securities6; portfolios ofhighly 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 flowsdo not match cash out flows (Transaction motive), as a safety stock to face forecast errors andunforeseen expenses (Precautionary motive) or to be able to react immediately whenopportunities can be taken (Speculative motive). If the cash level is too low and unexpectedoutflows occurs, the firm will have to either borrow funds or in the case of an investment –forego the opportunity.Such short-term borrowing of funds can be costly as can a lost opportunity by the lost returns ofrejected investments. Holding cash however also induces opportunity costs due to loss ofinterest.Cash management therefore aim at optimizing cash availability and interest income on any idlefunds. 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 andtherefore reflects the firm’s expected availability and need for cash.Working Capital Strategy  5
  6. 6. We will in the following look closer at working capital management using balance simulation7.The data is from a company with large fixed assets in infrastructure. The demand for its servicesis 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 workingcapital in the off-seasons and high levels in the high seasons. As the company wants to maximizeits 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 onaverage of only 11,1 days 1M (standard deviation 0,2 days) (across seasons) for turning suppliedgoods and services into cash:All the same, even then a substantial amount, on average €4,1M (standard deviation €1,8M) ofthe company’s resources, is invested in the cash conversion cycle:  6
  7. 7. In addition the company needs a fair amount of cash to meet its other obligations. Its firststrategy 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 andthereby a low contribution to the ROCE. This strategy can be described as being close to the redline in the seasonal graph above.When we now plot the two hundred observed (simulated) values of working capital and thecorresponding ROE (from now we use return on equity (ROE) since this of more interest to theowners), 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 awaste of time and effort.Now we turn to a stricter strategy: keeping a low level of cash through all seasons, using shortterm 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:  7
  8. 8. From this graph we can clearly see that if we can reduce the working capital we will increase theROE – even if we live in a stochastic environment. By removing some of the randomness in theamount of working capital by keeping it close to what is absolutely needed – we get a muchclearer picture of the effect. This strategy is best described as being close to the green line in theseasonal graph.Since we use pseudorandom8 simulation we have replicated the first simulation (blue line), forthe 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 thegraph below:The lax strategy (blue line) will have an average working capital of €4,8M with a standarddeviation 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 higherreturn to equity (se figure) and that the amount of working capital always is lower than under thelaxer strategy, we have not yet established that it is a better strategy.  8
  9. 9. To do this we need to simulate the strategies over a number of years and compare the differencesin equity value under the two strategies. Doing this we get the probability distribution fordifference in equity value as shown below:The expected value of the strict strategy over the lax strategy is €3,4 M width a standarddeviation of €6,1 M. The distribution is skewed to the right, so there is also a possible additionalupside.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 knowthat there will be strategies that are stochastic dominant, but proving one to be optimal might bedifficult. Given the uncertainty in any firm’s future operations, you will probably first have toestablish a set of strategies that can be applied depending on the set of events that can beexperienced by the firm.ReferencesFilbeck, G, Krueger, T, & Preece, D. (2007). Cfo magazine’s “working capital survey”: doselected firms work for shareholders?. Quarterly Journal of Business and Economics , (March),Retrieved from, M.K. (2010). Working it out: The 2010 Working Capital Scorecard. CFO Magazine, June,Retrieved from, J. & Copeland, T. (1986). Managerial finance, Eighth Edition, Hinsdale, The DrydenPressFootnotes 1. REL Consultancy. (2010). Wikipedia. Retrieved October 10, 2010, from Consultancy [↩] 2. [↩]  9
  10. 10. 3. Data from 1,000 of the largest U.S. public companies [↩] 4. COGS = Opening inventory + Purchase of goods – Closing inventory [↩] 5. Twenty of the one thousand observations have been removed as outliers, to give a better picture of the relation [↩] 6. 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’ [↩] 7. In the Monte Carlo simulation we have used 200 runs, as that was sufficient to give a good enough approximation of the distributions [↩] 8. Pseudorandom 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 [↩]   10