Treasury Management Advisor
2013 > Third Quarter
Understanding the Working Capital
Optimization Cycle: Improve Your Cash
Conversion Process
Having less cash tied up in receivables, payables and inventory means having
more cash available for paying down debt or investing in your business. The
working capital optimization, or cash conversion cycle, allows you to look at these
three areas to determine where your cash is tied up, says Jason Sweatt, Vice
President and Liquidity and Deposits Group Manager.
Jason recently shared his thoughts about working capital and what it could mean
for your business.
What is the working capital optimization cycle?
The working capital optimization cycle is a way of analyzing a company’s
receivables, payables and inventory to determine how the company handles the
cash in order to meet the short term liquidity needs of the operation.
The cycle provides insight into how much working capital it takes to run your
business.
Again, there are three aspects and perspectives to consider: receivables,
payables and inventory. A receivables perspective shows how many days it
takes to get paid. A payables perspective shows how long it takes to pay your
vendors. An inventory perspective shows you how long it takes to turn over your
inventory.
How do you calculate the working capital
optimization cycle?
Jason Sweatt
Vice President and
Liquidity & Deposits Group Manager
To calculate receivables (days sales outstanding): accounts receivable / sales
x 365. This will determine how long it takes to get paid for the products or
services you provide.
To calculate payables (days payable outstanding): accounts payable / cost
of goods sold x 365. This equation will tell you how long it takes to pay your
vendors.
To calculate your inventory (days inventory outstanding): inventory / cost of
goods sold x 365. This will reveal how long cash is tied up in inventory.
Days Sales Outstanding
+ Days Inventory Outstanding
– Days Payable Outstanding
= CASH CONVERSION CYCLE
To calculate the working capital optimization cycle (cash conversion
cycle): days sales outstanding + days inventory outstanding - days payable
outstanding. This formula will determine how long it takes to turn over your
cash. The final number will vary depending on your individual business and
industry. However, your business should look at its working capital optimization
cycle year over year to see how you are performing and compare yourself to your
peers. The information for publicly traded companies is available online to use
as a benchmark, while peer information may be provided by your banker.
How can a business manage these three aspects to
increase cash flow?
You want to get receivables in as fast as possible, and you do that by having the
right mix of treasury management services, such as by having your clients pay
you by Automated Clearing House (ACH) or wire. You can also offer a discount
for clients who pay quickly to encourage sustained prompt payment.
On the payables side, you want to avoid early payment to vendors, unless there’s
a discount for early payment. One method of managing your payments is to use
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Treasury Management Advisor
2013 > Third Quarter
a purchasing card, which most vendors accept. You want to hang on to your cash
as long as you can so that you can use it to invest or to pay down your debt.
Effective inventory management varies depending on the business, but each
business needs to optimize inventory levels with an understanding of the
funds that are tied up in excess supplies. Lean manufacturing and just-in-time
supplies are two popular inventory management techniques.
How can a business shorten its working capital
optimization cycle?
Again, businesses can benefit greatly from employing the right mix of treasury
management products. Taking checks to the bank yourself takes time, but a
remote deposit capture product allows you to deposit checks directly from your
desk and often provides a later deposit cutoff deadline for same-day credit than
branch deposits.
You can also use a lockbox, which speeds up the deposit process and provides
access to funds a few days sooner than if you had taken the money to the bank.
Cash-intensive businesses may want to use an electronic vault service. Cashiers
deposit money into an “on premises” vault that transmits the amount to the
bank, providing daily access to funds.
Why is understanding the working capital optimization
cycle so important?
The working capital
optimization cycle
is a strategic focus at Regions
Bank on which our bankers are
trained. For more information
about the process or how Regions
can help your business, email
Jason.Sweatt@regions.com or
call Jason at (205) 264-7419.
It allows you to make more money, which is done through either paying down
debt such as a line of credit or being able to invest funds quicker so you have a
rate of return on your cash instead of it stagnating in the cycle. It also provides
the additional insight necessary to make better informed financial decisions for
your business.
For example, in calculating the working capital optimization cycle of one client,
we noticed that from 2011 to 2012 the company’s receivables slowed by 10
days. The client said it was the nature of his business with today’s economy,
and his receivables contracts had increased to 60 days net pay.
Regions suggested the business convert its paper-based payments to ACH,
which would generate savings of more than $500 a month. The ACH process
also shortened the working capital optimization cycle by delivering funds
quicker and providing access sooner.