The pulse rate of any organisation is felt through its working capital. Working capital translates strategy into action. It is the lifeline. It represents the reality of what a company can effectively demonstrate as its strength. This is precisely why cash is still considered king, while profits remain opinions, writes FD Michael Nzule, finance and strategy director at Mitchell Cotts Group.
Do not throw any stones just yet. We will ignore the statement of comprehensive income (the profit & loss) in this discussion and focus on working capital.
In essence, we will elevate the importance of the statement of financial position (the balance sheet). Moreover, we will deliberately adopt a short-term perspective, arguing that the long term is an accumulation of short-term successes (or failures).
At its simplest, working capital refers to the difference between current assets and current liabilities. As an introduction to the foundational analysis of financial statements, this helps to understand the extent to which a company can meet its short-term obligations as they fall due. This tests liquidity. It is in meeting these obligations that a company must confront the challenges of growth and value. Any great strategy must fundamentally address these two crucial aspects of business.
Businesses exist to grow, while also preserving value for all stakeholders. Critical policies, such as dividend policy, are impacted by the effective management of working capital. This covers both the amount of the payout and its timing. This is the balance that effective working capital management must achieve.
Accountants have long explained why profits do not equate to cash. Simply put, despite all the sales made and profits reported, it remains valid that real cash must be traced and explained. The balancing act occurs here, and every successful CFO knows that a mismatch in the effective management of working capital elements will be detrimental, potentially spiralling costs without necessarily driving value. Optimised balance sheets address working capital to release cash that can be deployed for investment and growth, or to attract favourable external financing.
Operating working capital
Let us turn our attention to the make-up of working capital (sometimes referred to as operating working capital). The components typically include current assets—inventory (raw materials, finished products, work-in-progress), accounts receivable (debtors), prepaid liabilities, marketable securities, cash and cash equivalents, and other liquid assets. Current liabilities include accounts payable (trade creditors and other payables—borrowings), dividends payable, and taxes owed.
The CFO’s dashboard for operating working capital must always be complete, accurate, and timely. Time is of the essence in delivering healthy operating working capital. It is beneficial to defer outflows as much as possible while ensuring a healthy build-up of current assets that can easily be deployed to safeguard the long-term success and value of the company. The challenge lies in determining the right levels of each component and over what time horizon. CFOs must always find the real cash and deliver it when required.
Growth is typically fuelled by sales. The top line can be accelerated by selling on credit. After all, the more customers or consumers converted, the better for the company.
Selling on credit is advantageous, but cash conversion remains the lifeline. Production may not be supported by credit sales, and an imbalance here can be detrimental. Debtors arise from selling on credit, which is the demand side of the business. Sales teams must make sales and hit their targets. However, selling on credit has both benefits and drawbacks. Credit can be used to grow the business, but too much credit extended can threaten the lifeline of the company. The CFO has options that can be employed to optimise debtor balances, leading to faster unlocking of cash from accounts receivable.
The cash derived from optimisation can be reinvested to drive the multiplier effect, which is a key pillar for growth and returns for investors. The health of a company is heavily dependent on its cash balances. Too much is not ideal, while too little is disastrous. Striking the right balance is both exciting and crucial. Numerous initiatives can be pursued to ensure debtors are well managed, delivering the correct levels of cash.
Working capital
Most initiatives focus on early collection of debts and options for securing assets that can be liquidated in the event of distress. Securities such as bank guarantees or cash deposits are often used to secure debts. However, the process of debtor optimisation starts with the customer onboarding process. Credit analysis and structured acceptance criteria go a long way in mitigating credit risk. Companies are encouraged to implement watertight credit policies and credit control processes to ensure effective collection and minimise credit risks.
Another key component of working capital on the CFO’s radar is accounts payable. This represents cash outflows. To preserve cash balances, outflows must be planned and executed effectively. Accounts payable can also serve as a source of short-term financing. CFOs are encouraged to finance working capital through favourable accounts payable (creditor) contracts. This helps defer cash outflows while maintaining healthy business relationships with suppliers.
However, this should not be done so aggressively as to undermine the essence of business partnerships. Depending on the relationships held with suppliers, options such as supplier financing can be pursued. Suppliers can liquidate their invoices through financiers and continue to meet trade supply obligations.
When managing supplier performance, key performance agreements are necessary. These include parameters like payment-to-terms (PTT), order processing time, ledger reconciliation, delivery times, ethical sourcing compliance, health and safety, and regulatory compliance. The costs of such optimisation initiatives should not disrupt business or undermine the targeted supply chain optimisation goals. Again, this is a delicate balancing act that should always be sustainable.
Inventory levels represent cash that is not liquid. The faster inventories are converted into cash, the better for the health of the company. CFOs are encouraged to implement inventory optimisation strategies. Inventory optimisation refers to the process of strategically managing and controlling stock levels to maximise efficiency, minimise costs, and meet customer demand. Initiatives may include collateral management and consignment stock management.
In collateral management, inventories are taken off the balance sheet and financed by third parties (financial institutions), which hold the title to the goods. Third-party collateral managers are deployed to manage the inventory, including drawdowns and assurance of inventory holding levels. The ultimate owner of the inventories only draws down what is required for manufacturing or distribution upon payment to the financiers for the consignment. This strategy ensures that inventories are professionally managed while meeting financing obligations. The entity is free to focus on areas of competitive advantage, such as sales and marketing or manufacturing excellence. Further optimisation may include outsourcing the entire procurement process and managing the complexities of importation, customs, and shipping logistics.
From the components evaluated above, it is clear that the cash conversion cycle is the pulse rate of companies. It determines short-term success, translates strategy into action, preserves value, and dictates the pace of growth while ensuring strategic delivery. This is one of the pillars of success in the CFO role. Working capital optimisation is part of balance sheet optimisation, not only to manage risk but also to ensure the right balance between assets and liabilities, unlocking value.
