The ultimate cheat sheet to improve working capital
Thursday, July 10, 2014
The 2008 recession burned a lot of construction and building companies and made them become more financially disciplined. This discipline, however, is being challenged by improving market conditions. Since improving economies present high financial risks, it is more important than ever to understand and improve a company's working capital position.
How can you do it? This article provides you with a cheat sheet.
What is working capital and why does it matter?
Investopedia has a nice high-level definition, reporting that working capital is "a measure of both a company's efficiency and its short-term financial health." It can be calculated using this straight-forward formula:
Working capital = current assets - current liabilities
The importance of working capital is hard to understate. As the old business saying goes, "Revenue is vanity, profit is sanity, but cash is king."
Access to working capital is especially important in a recovering economy where there are so many opportunities to grow. Funding growth opportunities requires access to cash.
When the entire construction industry is riding a growth wave, everyone will be clawing around for working capital — which means it's hard to collect receivables and harder to stretch out your own payables. This cumulative market effect is discussed in more detail in the section below: What it means when everyone is trying to decrease receivables and increase payables.
CFO.com has two great white papers that address an organization's working capital challenges. "Cash & Liquidity Management" reviews survey results that focus on what companies will be doing in the coming year(s) to manage their cash and liquidity. "Think Strategically ... Pay Strategically" is a great resource to get companies thinking about how they can use their receivables and payables to improve their working capital.
How companies can influence working capital
CFO's "Think Strategically ... Pay Strategically" white paper introduces the concept of thinking about receivables and payables in a way that improves a company's working capital position. When it comes to what companies can do to influence their working capital, the conversation starts there.
In the "Cash & Liquidity Management" report, three "main dimensions of working capital" are identified: receivables performance, inventory management and payables performance.
In other words, if companies are going to influence their working capital position, they are going to make some adjustment in one or more of these three areas.
The less receivables a company is carrying, the more working capital in their coffers. Likewise, the more payables a company is carrying, the more working capital they retain. And the less money they have in inventory building up in a warehouse, again, the more working capital they retain.
In the CFO.com report identifying these "three main dimensions," survey responders were asked which of the three dimensions will be the highest priority in the year ahead. The number one response was receivables performance.
Similarly, the report also asked, "What changes would contribute most to [improved] cash-flow management?" The responses similarly cluttered around receivables performance goals, with the top results being "motivating account relationship holders to support collections activity" and "delivering better reports on account delinquencies to account relationship holders."
The takeaway here? There are three primary ways companies can influence their working capital, but far and away, the key area is in improving receivables performance.
What it means when everyone is trying to decrease receivables and increase payables
There are only three main ways to influence working capital, and here's the deal: Every company knows about them. Accordingly, every company is trying to reduce their receivables and increase their payables.
See the problem?
Those collecting receivables are confronted by a marketplace trying to drag out their payables, thus making collecting receivables more difficult. Those trying to drag out their payables are confronted by a marketplace getting more aggressive about collecting receivables, thus making slow-paying more legally dangerous and costly.
The friction here is exasperated by market forces starving companies of working capital. What's a company to do?
Receivables performance packs the most punch when trying to influence working capital. And when it comes down to it, getting better receivables performance will require your company's receivables to be prioritized by the payer. You must convince the paying party not only to pay your debt above other debts, but more importantly, to pay your debt instead of letting it drag out for their own working capital goals.
Getting companies to prioritize your invoices and payment applications is both a science and an art, but for those in the construction industry, it is riddled by problems related to the industry's complex payment chain. Strong credit and collection policies are key.
But even more importantly, preliminary notices have been proven to increase the priority of a construction company's invoices and payment applications. Leverage this tool.
The working capital concept is not overly complicated. Understanding how to make a positive working capital impact on your company is fairly simple. Actually undertaking efforts to successfully influence working capital, however, can be difficult — especially in a marketplace and industry where working capital is tight.
Research shows that receivables performance is key in making a working capital impact, and to achieve improved receivables performance, it is crucial to get your company's receivables prioritized by paying parties. Think tactically about how you can do this, and in the construction industry, leverage security rights and preliminary notices to achieve prioritization.
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