To recap, we care about working capital because it is a direct driver of free cash flow and everyone loves free cash, ergo, everyone cares about working capital. But, before we talk about improving working capital, it’s important we understand how to measure and monitor it. If we measure it in a consistent way, we’ll learn the effectiveness of our improvement initiatives and may even find ways to create more cash from the same accounting earnings.
So, what are we actually measuring? We’re measuring something called working capital absorption. That means, we’re measuring how much cash is absorbed by our working capital profile. The best case is negative absorption (production of surplus cash) and the worst case is total absorption (no one pays their bills; imminent insolvency). The most common way to measure this absorption is via a ratio of working capital and sales (WC/Sales), which conceptually tells us what percentage of sales is tied up in paper earnings and not yet realised as cash.
The genius of WC/Sales is its simplicity and scalability. Even as a business grows, we can monitor how our working capital profile (and working capital absorption) is changing with that growth. Ideally**, it will get better as our customer and supplier power increases through shear size**, but it can also get worse if our growth is borne by lower credit standards and less reliable debtors. Either way, WC/Sales is best measured weekly or even daily and viewed as a trend over weeks or months.
For a more granular measurements, we can look at the day measurements. That is, debtor days, creditor days and inventory days. Don’t be fooled, these are just ratios converted to turnover measures. For example, debtor days is simply Debtors/Sales multiplied by the number of days in the year (note: some people use year-end debtors and some use average debtors). The creditor and inventory day measures are the same, except they’re a ratio denominated by COGS rather than sales, for obvious reasons. In a conceptual sense, these day measurements tell you on average how long those items are turned in a year. For example, debtor days of 45 means on average debtors are settling their accounts within 45 days.
In practice, I like to use WC/Sales and debtor/creditor/inventory days in unison. If I see a portfolio company’s WC/Sales increasing, I immediately look to my day measurements to find the offending driver. Often there is a single offending driver, which I can place most of my focus on to help management rein in. However, there are often cases where that driver has become unruly due to some uncontrollable factor, like a structural shift in the market. In those instances, I can focus my attention on an opposing driver to help management rein in the broader WC/Sales metric.
Since working capital can be influenced greatly by a single payment or shipment, it is important to measure it often and monitor trends continuously. In fast growing businesses, you won’t believe how quickly poor working capital management can yield devastating results.
Working Capital Series: