Working capital should always be evaluated in relation to the cash flow from operations. There are certain industries, for example, where companies have negative working capital, and that’s normal! — such as in the food retail sector, where customers pay in cash, inventory is kept to a minimum, and suppliers offer payment terms…
What factors increase working capital requirements? (These are the factors that, in turn, reduce cash flow!)
- The contractual payment term granted to the customer: the longer it is, the more working capital requirements increase
- Late payments: When they increase, working capital requirements rise
- The time it takes to resolve disputes: the longer it takes, the higher the working capital requirement becomes, because the invoices subject to dispute cannot be collected
- The time it takes to convert customer orders into invoices: the longer the period between the customer’s commitment—which creates an obligation for the company—and the issuance of the invoice—that is, the delivery of the goods—the higher the working capital requirement (WCR) becomes
- Inventory turnover: the larger the inventory and the longer it takes to be converted into merchandise sales or processed into finished goods, the more it increases working capital requirements
- Supplier payment terms: the shorter the payment term, the more it increases working capital requirements
- Supplier discounts: The more discounts you offer suppliers, the higher your working capital requirements become
- An increase in revenue —assuming constant customer and supplier payment terms and inventory levels—that is, when business activity expands (revenue growth)—results in accounts receivable accounting for a larger portion of assets and thus generating more working capital requirements. This reality demonstrates that a company’s growth and development require financing. For example, when a company’s revenue is 360 million euros for a year, one day’s revenue is worth 1 million euros. If revenue increases to 720 million euros, the value of the same day’s revenue rises to 2 million euros. Accounts receivable, which tie up working capital, represent 30 days of revenue; in the first scenario, they amount to 30 million euros, while in the second, they amount to 60 million euros. To finance this increase in revenue, working capital must therefore increase by 30 million euros. The key challenge in this case is to effectively manage all aspects of working capital, without allowing payment terms to slip, for example, or by using financing techniques tailored to this situation: converting accounts receivable into cash through factoring, inventory-backed financing, or specific supplier-linked credit facilities…
- Non-operating items: other receivables that increase—for example, due to intra-group transactions, such as assistance provided to a subsidiary in the form of a current account advance—as well as other payables or tax and social security receivables that are repaid more quickly, all contribute to an increase in working capital requirements.
What factors reduce working capital? (These are the levers that improve cash flow!)
- The reduction in contractual payment terms granted to customers
- The reduction in late payments by customers
- The practice of requiring customers to make a down payment when placing an order
- Appropriate provisioning for doubtful accounts or inventory write-downs
- A decline in business activity as the proportion of accounts receivable in total assets decreases
- Inventory Reduction
- Using inventory as collateral to secure financing—for example, through inventory pledges
- The use of accounts receivable in financing transactions, such as factoring or securitization: accounts receivable are reduced on the asset side as they are used to secure a cash advance until maturity.
- The non-recourse assignment of receivables: This is a transaction in which accounts receivable are sold and permanently removed from the balance sheet in exchange for cash. The value of such assignments is often less than the face value of the accounts receivable, especially in the case of doubtful accounts.
- Extending payment terms for suppliers: In practice, it is sometimes useful to vary payment terms by supplier, placing greater emphasis, for example, on strategic suppliers.
- Non-operating items: other receivables are decreasing; other liabilities and tax and social security receivables are increasing
Thus, an analysis of working capital can help identify the actions that need to be taken to correct poor performance.
Conversely, the measures implemented are reflected in working capital requirements, and this summary table provides an opportunity to visualize the impact on cash flow.