Working Capital Management
Freeing cash flow
in your business
pwc.com.au/privateclients
Executive summary
Your company is growing. Sales are skyrocketing, you’re taking on
new people and you’re looking at expanding. Business is booming
and everything’s in order. Right?
If you scratch below the surface, you may find everything is not
alright – in fact, some things may be very wrong.
When you are not sure if your next sale will result in increased cash
flow, you may be ‘growing broke’ and this publication is for you.
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PwC
When things are looking good and
you’re focused on taking your business
to the next level, it can be easy to look at
the big picture; but like so many things
in life, the devil is in the detail.
When you consider growing your
business, you’re most likely driven by the
desire to increase your customer base,
win market share and expand into new
products and markets.
Ambitious growth strategies – in
particular those which shift the
attention from managing the here and
now to focusing on the end result – can
have unpleasant side effects.
These unforeseen consequences cannot
only deprive a business of cash flow from
a build up of inventories and accounts
receivables, but also result in inefficient
operational processes and sub-optimal
capital management. This can lead to
lower returns on assets, riskier capital
structures, stress on dividends and
depressed business valuations.
With a diverse range of clients across a
wide range of industries, our combined
experience has taught us that private
businesses must balance growth and
profitability with actively managing
working capital. The most successful
companies manage not only the profit
and loss statement, but also the balance
sheet and working capital.
Working capital management (WCM)
focuses on maintaining efficient levels
of both current assets and current
liabilities. It ensures a company has cash
flow in order to meet its short-term debt
obligations and operating expenses,
which can be a particular challenge
during periods of strong growth.
Given the time it takes to recognise
profit and generate positive cash flow,
businesses undergoing rapid growth
without a WCM system in place can be
starved of funds.
By adopting a working capital
management system that
includes effective management
of debtors, procurement and
supply chain, a company can
improve earnings and cash flow.
WCM can benefit any business at any
stage in its life cycle.
By implementing performance
improvement initiatives and
reducing working capital
intensity, the finance function
can have a direct link to
increasing the value of the
business.
This focus can shift the role of the
finance team from a perceived cost
centre to playing a vital strategic role
in the business.
In order to achieve maximum savings
from WCM programs, businesses must
address the often hidden relationships
and levers between different
components of working capital across
the business.
For this to be successful WCM initiatives
need the commitment and support of
your leadership team.
Significant improvements in WCM
should be a strategic focus of the finance
function, as businesses often hold more
working capital than necessary.
“ WCM can benefit any business
at any stage in its life cycle.”
This publication looks at:
• The benefits of efficient working capital management and the impact on business value.
• A case study demonstrating the potential to release cash by reverse engineering
common working capital metrics.
• Identifying the main levers of inventory, receivables and payables balances.
• Linking the operating elements of working capital to value creation.
• Common indicators and trigger points to instigate a working capital review.
• PwC’s WCM value proposition.
Working Capital Management
3
There is a clear link
between working
capital management
and business value.
Contents
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PwC
05
Working capital
management
07
Why do you need to
manage working
capital?
09
Releasing cash flow
through debtors
10
Using creditors to
improve cash flow
11
Freeing cash with
inventory
12
How do I know if I have
a problem?
13
PwC’s working
capital services
14
Conclusion
15
PwC Private Clients
Working capital management
Working capital management (WCM) is the art of minimising
cash absorbed in a businesses operating cycle.
The timing difference between
recognising profit and generating
positive cash flow can create cash flow
or liquidity problems for a business.
This can be the result of costs associated
with acquiring and holding inventory
as payment is required in advance of
making a sale. If the sale is made on
credit terms, it takes even more time
to collect the cash. Depending on the
industry, this cycle could take in excess
of ninety days, meaning the business
must fund this timing difference.
When working capital is expressed
in terms of days it is commonly referred
to as the operating cycle of the
business, the cash conversion cycle or
the cash-to-cash cycle (C2C). The C2C
cycle of a business reflects the time in
days it takes for a company to convert
the purchase of inventory into sales and
collect the cash.
The quantification of this timing
difference is known as the working
capital requirement of a business.
The time lag from purchasing inventory
to making a sale and finally collecting
cash creates a timing difference between
profit and cash flow.
Start
DPO
$100,000
purchase inventory
Payment for
inventory due
Inventory sold
to customer
for $130,000
Day 1
Cashflow
Day 30
- $100,000
Day 60
C2C
90 days
• Days inventories outstanding (DIO)
= average number of days that
inventory is held.
• Days sales outstanding (DSO)
= average number of days until
a company is paid by its customers.
• Days payables outstanding (DPO) =
average number of days until a company
pays its suppliers.
DIO
DSO
Customer
pays
Day 120
$130,000
In the above example, if an overdraft is used to fund
working capital throughout the C2C cycle at 10% p.a,
the $30,000 gross margin is reduced by finance costs
of $2,500 or approximately 8.3% of gross margin.
The secret to unlocking cash
flow in the business can be
found in the operations of
the value chain.
Working Capital Management
5
DIO
Supply
chain
strategy
Packaging and
shipping
SKU
management
Storage and
logistics
Supply chain
Management
Production
and
assembly
Volume
forecasting
Production
scheduling
WCM and
C2C cycle
Planning
Sourcing
ns/Logi
sti
ratio
e
cs
Op
Once you view working
capital management as
a system, you can steer,
influence and manage the
drivers to free up cash.
Inventory
(DIO)
WCM
WCM
and C2C
Cycle
M
ar
DSO
en
t
Creditors
(DPO)
m
s&
ke
C 2 C C ycle
ti n
re
S ale
Debtors
(DSO)
g
o
Pr
cu
Sales
strategy
Purchasing
strategy
Pipeline
management
After Sales
Service
Suppliers
evaluation
Planning and
preparation
Sales offers
Cash
collections
and control
Rebates &
discounts
Revenue
Debtor
Management
Credit
control
PwC
Settlement
and cash
management
controls
Procurement
Management
Contract admin
processing
Sales order
processing
Fulfilment
6
Customer
acceptance
DPO
Tendering
and
bidding
Negotiating
and evaluation
Contract
relationship
management
Contracting
Why do you need to manage
working capital?
Alignment with strategy
The C2C cycle can be analysed and
viewed in light of a company’s strategy.
A business that competes on price
should have tight working capital
policies and manage its inventory and
receivables days with discipline. This
includes short credit terms for customers
and the willingness to accept stock-outs in
order to avoid holding excess inventory.
The stage of maturity of an organisation
will also have an impact on the working
capital requirements of a business.
Those that are experiencing fast growth,
declining growth or financial distress
due to a broken capital structure are
most likely to face cash constraints and
therefore require strict WCM.
On the other hand, a niche player is more
inclined to extend favourable credit terms
to reflect a business model that charges
higher prices to its customers.
Net working capital absorption
450m
400m
B
Optimal growth
C Fast growth
A
Sales $
350m
Declining
300m
D growth
250m
200m
F
150m
The goal of working
capital management is
to optimise growth and
move from position C
to A as shown here.
E Financial stress
Downsizing
100m
20m
25m
30m
35m
40m
45m
Net working capital (NWC) $
“ Businesses that ‘grow broke’ typically
experience deteriorating cash,
working capital metrics and exhibit
a lack of accountability.”
Working Capital Management
7
Improving business value
Worked example
The interplay between working capital
absorption and value:
$100 / (20% - 3%) =
$588 or 5.3 times EBITDA
There is a clear link between WCM and value creation.
Assume now the business makes improvements to the
rate of working capital being absorbed into the business
and generates $130 in free cash flow, with risk, growth
and EBITDA remaining constant.
Creating business value is all about generating returns that
exceed the level of risk taken. Cash is said to be king, and
shareholders value growth in their investment.
Therefore business value can be expressed as a function
of three inputs; free cash flow, risk and growth.
Value = Free cash flow/(risk less growth)
The valuation framework would produce a valuation
of $765, calculated as:
$130 / (20% - 3%) =
$765 or 7 times EBITDA
Given the above valuation mechanic there are three
general options available to management for increasing
the value of a company:
1. Increase the cash flow available to debt
and equity providers.
2. Lower risk for the same reward.
3. Increase the rate of growth.
Assume a company generates $100 in free cash flow
and $110 in earnings before interest, tax, depreciation
and amortisation (EBITDA). Risk as measured by the
company’s cost of capital is 20 percent, and based on
historical data the future growth rate is expected to be 3
percent per annum.
Using the valuation framework above, the company
could be valued at $588.
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PwC
In this example, management can increase
a company’s value through operating
efficiencies focused on working capital
improvements.
Increased efficiencies will lower the capital
invested in the company and therefore
allow surplus cash to be distributed back
to shareholders or reinvested in strategic
initiatives.
It is worth noting that businesses with
inefficient working capital management are
often acquired at a discount.
Releasing cash flow
through debtors
Debtors in a business are
typically monitored and
managed using a profile of
ageing that segments the
balance based on the number
of days outstanding; being 30,
60, 90 and 120 days past due.
Days sales outstanding (DSO) is commonly
calculated by the following formula:
DSO= (Accounts receivable/sales) x days
in period.
Worked example
Consider a private importing business that has annual sales of $100
million and an accounts receivables balance at year end of $15 million.
DSO can be calculated as follows:
$15/$100 x 365 = 55 days of credit sales that are unpaid at the end
of the period.
If the importing business was able to reduce the DSO from 55 days
down to 44 days then the potential to free up cash can be calculated by
reverse engineering the traditional DSO calculation as follows:
Potential to free cash (DSO) = (Sales/days in period x target collection
terms) – accounts receivable balance
Potential to free cash (DSO) = ($100,000,000/365 x 44) – $15,000,000
= $2,945,205
In this example, collecting debts on average in 44 days
instead of 55 days would free up $2.9 million in cash,
which could be returned to shareholders or used to
retire debt.
Common mistakes
• No credit policy.
• No reference checks.
• No progress payments.
• No incentives for early payment.
Working Capital Management
9
Using creditors to improve cash flow
Creditors, like debtors are
typically monitored and
managed using a profile of
ageing that segments the
balance based on the number
of days outstanding; being 30,
60, 90 and 120 days past due.
Worked example
Consider an importing business that has cost of goods sold of
$40 million and an accounts payables balance at year end of $2
million.
DPO would be calculated as follows:
$2/$40 x 365 = 18 days
Days payables outstanding (DPO)
is commonly calculated by the
following formula:
If the importing business increased DPO by 12 days, representing
30 days credit terms, the potential to free up cash can be
calculated as follows:
Days payables outstanding (DPO)
= Accounts payable/cost of
sales x days in period.
Potential to free cash (DPO) = (cost of sales/days in period x
target settlement terms) – existing accounts payable balance.
Potential to free cash (DPO) = ($40,000,000/365 x 30) –
$2,000,000 = $1,287,671
In this example, settling accounts payable in 30
days instead of 18 days would free up almost
$1.3 million in cash, which could be returned to
shareholders or used to retire debt.
However, it is worth noting that days to pay creditors often
depends on working capital management philosophy.
Some companies will deliberately defer settlement or stretch
creditors to preserve cash. Other businesses may pay creditors
quickly to achieve favourable return service and to maintain a
reputation in the local markets in which they operate.
Common mistakes
• Settling creditors too quickly.
• Limited negotiation skills and
lack of focus on payment terms
from buyers.
• Limited controls on the interface
between vendor master files and
online payment systems.
• No centralised procurement
function.
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PwC
Freeing cash with inventory
Depending on the industry,
inventory can be the largest
component of working capital
that ties cash up in a business.
If inventory is not turned
over regularly it incurs
overheads such as storage,
administration, handling and
insurance. It is also subject
to risk of damage, theft,
deterioration, obsolescence
and may even be perishable.
The amount of inventory held at any
time depends on balancing the holding
costs against the opportunity cost of
stock outs. Therefore, deciding when
an operation should replenish its
inventory is a critical success factor.
From our experience, many companies
overstock simply by purchasing goods
greater than historic usage patterns
which leads to excess working capital.
Worked example
Days inventories outstanding (DIO) is a commonly used key performance
indicator and is calculated by the following formula:
DIO = inventory/cost of sales x days.
Consider an importing business that has cost of goods sold of $40 million,
and stock on hand at year end of $8 million.
DIO would be calculated as follows:
$8/$40 x 365 = 73 days
If the importing business decreased the inventory days by 13, representing
two months worth of stock, the potential to free up cash
can be calculated as follows:
Potential to free cash (DIO) = (cost of sales/ days in
period x target inventory days) – stock on hand.
Potential to free cash (DIO) = ($40,000,000/365 x
60) – $8,000,000 = $1,424,658
In this example, turning over inventory on average
in 60 days instead of 73 days would free up $1.4 million
in cash for the business.
From our experience many
companies overstock
simply by purchasing
goods greater than historic
usage, which drains cash.
Working Capital Management
11
How do I know if I have a problem?
Poor working capital
management can result in
liquidity risk to a business –
it can cause the business to
be in a position where it is
unable to pay its debts as
and when they fall due.
Traditional measures of liquidity
including current and quick ratios
can actually mask systemic working
capital issues.
The current ratio as measured by
the level of current assets compared
to current liabilities has historically
been accepted as being favourable
when it exceeds a ratio of 2:1.
However, this measurement can be
misleading if the organisation has a
poor record of collecting debts and/or
has an accumulation of slow moving
and obsolete inventory.
Common indicators and
triggers for a working
capital review
• The business is generating strong
sales, but never seems to have
enough money.
• The business has deteriorating
cash, working capital metrics and
exhibits a lack of accountability for
managing the balance sheet.
• The business is making profits, but
cash flow is tight.
• You are uncertain if the business
can pay a dividend.
• You find yourself regularly bumping
up against credit limits.
• There is an inability to fund future
capital expenditure needs from
operations.
• You have invested in new systems,
but your cash management
performance hasn’t improved.
• Your bankers are suggesting you
review your operations.
• You never know what your cash
position is.
• You have large differences between
profit and cash flow.
• You are not sure how much cash is
available.
• You have large amounts of money
tied up in inventories and/or
debtors.
• You have difficulties in managing
seasonal fluctuations.
• Your bank overdraft and finance
lines are drawn down.
• You are approaching or have
breached bank covenants.
• You experience difficulty in raising
additional capital.
“Liquidity measures can be ‘fools
gold’ – traditional measures of
liquidity including current and
quick ratios can actually mask
systemic working capital issues.”
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PwC
• You are planning to sell the business
in the future.
• You are experiencing high levels
of working capital investment
compared to sales revenue.
PwC’s working capital services
Release cash from
operations
Inventory
Accounts
payable
Sales
What we do
We take a practical, operational approach
to improving the value of your business
at a personal level. Our approach goes
further than just an analytical high level
review; we will examine your operations
to identify improvement opportunities to
increase cash flow. Once we’ve worked
with you to uncover how you can do
this, our methodology has identified in
excess of 200 best practice initiatives
that can be implemented to generate
tangible, measurable improvements in the
management of working capital.
We don’t just measure performance,
we improve it.
How we do it
Accounts
receivable
Our approach to unlocking the benefits of
working capital improvements is based on
a best practice gap analysis to determine
if there are opportunities to implement
operational improvements.
Cash
We analyse existing business problems
and develop tailored plans for
improvement by providing specialised,
objective advice based on our knowledge
and expertise in industry best practice.
Best practice is the most efficient and
effective way of accomplishing a task,
based on repeatable procedures that
have proven themselves successful
over time for large numbers of
businesses. A procedure that meets
best practice should achieve the best
results with the least amount of effort.
Benefits
Increasing cash flow will
enable you to reduce the
capital intensity of your
business, allowing you to
increase the return or yield
the business generates.
Increasing free cash flow in the
business will also make the business
more valuable as measured by
enterprise valuation models based on
discounted cash flow techniques.
This means the business will be
worth more, allowing owners the
opportunity to extract additional value
on exit.
Freeing up additional cash also gives
management more options, including:
• The increased ability to pay higher dividends.
• The ability to pay down debt to reduce finance
charges and increase net operating profit.
• Improved credit rating and increased capacity to borrow
and service additional debt to fund future growth.
• The ability to re-invest in the businesses through
additional capital expenditure and research
and development.
• The ability to pass on savings to customers to improve
competitiveness and increase market share.
• Creates flexibility and opportunity to achieve an
optional capital structure for the business.
Typically our working
capital services
pay for themselves,
meaning a net gain
to the business.
Working Capital Management
13
Conclusion
The most successful companies apply the same discipline to capital management as
to managing the profit and loss account. They understand the C2C value chain along
with the working capital levers and actively address the root causes of tied-up cash.
By doing this they make the company more valuable for shareholders and more
attractive to debt providers.
Additional revenue growth
$1,000
$0
Are you growing broke?
Cost of Sales
-$400
After
additional
funding
$0
Gross
margin
$600
Growing broke –
next $1,000
of sales volume
Additional
Debt
+$60
After
working
capital
$(-60)
AR
Days
-$60
AP
Days
+$30
Operating
Expenses
-$300
Fixed
Costs
-$100
Tax
-$63
Inv
Days
-$90
Dividends
-$67
Interest
-$10
Retained
income $60
The marginal cash flow represents the cash inflow generated from
incremental revenue less the cash outflows to cover incremental variable
cost of sales, incremental variable expenses and the incremental
investment in working capital.
In the above example, a fast expanding business is ‘growing broke’. An
additional $1,000 of sales results in earnings, but after working capital
absorption it experiences a $60 cash shortfall, which needs to be funded.
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PwC
EBIT
$200
PwC Private Clients
PwC Private Clients uses it’s proprietary business improvement process to help private business
owners and individuals improve business performance and realise ambitions. Often the first
step to improve business performance is an assessment of financial health using PwC’s own
financial X-Ray® management tool.
Making the invisible visible
Financial X-Ray® vital
signs report
PwC’s Financial X-Ray® can highlight the
absorption (good or bad) of working capital in a
business to isolate if there is a problem.
The Financial X-Ray® vital signs report allows
businesses to look at management performance,
positive or adverse trends, funding decisions,
the actual cash generated and other meaningful
financial data, including marginal cash flow and
working capital management.
PwC’s Financial X-Ray® is a one-page overview
of a businesses financial results that turns
normal balance sheet and profit and loss
data into meaningful financial management
information.
Working capital metrics can be analysed and
benchmarked against industry standards as well
as management objectives.
Private Clients Advisory – service offering
Horizon 1 services (Definition of business potential)
Horizon 2 services (Roadmap)
•
•
•
•
•
•
•
•
• Financial Health Assessment –
Financial X-Ray®
• Strategy design and strategic planning
• Business model design and review
• Activity based management and
value driver analysis
• Value and wealth creation plans
• Organisational design and evaluation
• Capabilities and resource
assessments
• Decision support analysis – what if Financial X-Ray®
• Growth 100 day action plans
• Waste audits
• Pre-lend reviews
• Credit risk assessments – Bankers X-Ray®
Commercialisation plans, R&D and grant assistance
Commercial due diligence
Market research and industry analysis
Competitor analysis
Customer and product research
Business plan design and review
Business case development
Financial modelling
1. Early stage
Develop products
and services
ss
3.
M
a
•
•
•
•
•
•
•
•
Strategic review and due diligence
Process improvement
Risk management & governance
Balanced and strategic scorecard
design and implementation
Financial improvement plans – X-Ray®
Working capital improvement
tu
Cost reduction & restructuring
rit
Finance function effectiveness
y
Customer, portfolio and margin analysis
Cultural assessments and change management
Remuneration models and employee incentive plans
Succession planning
Corporatisation
Journey to
sustained
performance
ine
•
•
•
•
bus Dev
ine e
s
ma
el
p
lo mod
s
M a n a ge t h e b u s
Horizon 3 services
(Accelerate performance)
2.
G
e
tag
hs
wt
ro
Identify and
define markets
er D
at ev e
ing lo p
syst
ems
Horizon
op
Dev p
n a g e l o st e m
e m ent sy
Working Capital Management
15
pwc.com.au/privateclients
Alister Berkeley
Director, Private Clients
Sydney
Tel: (02) 8266 0022
Mob: 0415 757 492
Email: alister.berkeley@au.pwc.com
© 2013 PricewaterhouseCoopers. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers a partnership formed in Australia,
which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.
16 PwC
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