The most inexplicable event for a senior-level manager is to see a profit at the bottom of the income statement, and yet field a request from the accounting staff to obtain more cash, because there is not enough on hand to meet all current cash requirements. What happened? There may be large asset purchases, but these normally require the approval of senior management, so everyone is aware of them. The primary remaining reason why there is a cash outflow is that working capital requirements have increased. A controller is frequently called on to review the elements of this key investment area and tell management why increases have occurred and how to reduce them. This post reviews the three elements of working capital and how to evaluate them.
There are three components to working capital. The first two: accounts receivable and inventory, represent a net usage of cash. The third component: accounts payable, is a source of cash.
Working capital = accounts receivable + inventory – accounts payable
Thus, to reduce the investment in working capital, then, one must either:
- decrease the amount of accounts receivable; or
- decrease the amount of inventory, or
- increase the amount of accounts payable.
However, before taking action to alter the working capital investment, it is best to first understand what caused any increase in working capital that is now the focus of management attention. Accordingly, a controller should review the following most common causes of working capital changes to find the culprit:
Working Capital Element#1: Accounts Receivable
- Credit granting problems. If the finance staff is doing a poor job of granting credit to new customers, or if there is no process at all for doing so, then it is likely that some customers will take advantage of the situation and purchase more from the company than they can pay for, which will result in an increased company investment in accounts receivable.
- Credit review problems. Once a customer has been granted a credit limit by the finance staff, this does not mean that the customer’s ability to pay must never be reviewed again. On the contrary, this should be at least a yearly exercise, so that the company can spot any customers who are having difficulty paying on time and reduce their credit. Without this annual review, the financial condition of a few customers will worsen, resulting in their inability to pay on time and an increased company investment in accounts receivable.
- Credit hold problems. Even if there is an excellent credit granting and review process, a company is still in danger of shipping to customers with poor credit ratings if the shipping department is not informed of any customers being on credit hold. When this happens, shipments will go to customers who are not paying on time, which results in an increased company investment in accounts receivable.
- Collection problems. Some customers will not pay invoices on time, either because they lack the funds, or because they have a problem with the invoice that must be resolved before they will pay. In either case, it is the job of the collections staff to contact the customers to determine the nature of any problems, correct them, and follow up with the customer to ensure that payment is then made. If this function does not exist or is poorly run, then the company’s investment in accounts receivable will increase.
- Product return problems. Sometimes, customers will return products and then not pay for the related invoices. Though this is acceptable behavior when the customer obtains a return authorization from the company, it is quite a different matter when the customer simply returns volumes of product that it does not use and refuses to pay the related invoices. This lapse can be solved by creating an effective return authorization program that rejects all other returned goods. Without it, a company’s investment in either accounts receivable (because of the unpaid invoices) or inventory (because of the returned product) will increase.
- Billing problems. If a company cannot send its customers error-free invoices, then the customers will refuse to pay them until the errors are corrected, which usually involves mailing out either a credit or a new invoice; in either case, the problem is usually not discovered until the invoice is overdue, followed by a few weeks for the revised invoice to reach and be processed by the customer, followed by another week or two for the payment to arrive at the company. Thus, the time lag associated with correcting the problem will result in an increase in the company’s investment in accounts receivable.
- Sales growth. If company sales increase, then the investment in accounts receivable will inevitably increase alongside it and in the same proportion. For example, if all customers pay in 30 days and sales are $1 million per month, then there should always be a minimum of $1 million in accounts receivable. However, if sales double to $2 million per month, then so too will the accounts receivable investment.
Working Capital Element#2: Inventory
- Production obsolescence problems. Some inventory will not be used. This may be due to the withdrawal from the market or poor sales of a specific product, for which all related finished goods, work-in-process, and raw materials will now languish. When this happens, the company will have invested an excess amount in inventory.
- Engineering design change problems. Some raw materials or work-in-process items will never be added to finished products, because the engineering department switched to a new component prior to using up all available stocks of the old parts. As a result, these old parts will never be used and will stay in the inventory. Since the inventory now includes both the old and replacement parts, the company has increased its investment in inventory.
- Purchasing overage problems. The purchasing staff may be tempted to order parts in extra-large quantities, which generally fetches a lower per-unit price, while also reducing the number of orders that the purchasing staff must place. However, this leads to much larger stock of raw material items in inventory, as well as an increased risk of inventory obsolescence, because it may take years to use up all of the stock. Thus, the company’s investment in inventory is increased.
- Costing methodology problems. If the accounting staff chooses to alter the inventory costing method, this can have an impact on the total investment in inventory. For example, if the most recent layers of costing in the inventory costing database are the most expensive, switching to the first in-first out (FIFO) method from the last in-first out (LIFO) method will increase the cost of what is in inventory.
- Sales forecasting problems. If the sales staff incorrectly forecasts an excessive quantity of sales, then the production scheduling staff will order the production of an excessive quantity of finished goods, which will increase the company’s investment in finished goods inventory until the goods are eventually sold.
- Production methodology problems. If a company has difficulty in controlling the flow of production, or is using a production system that tends to require more inventory, then there will be an excess amount of raw materials and work-in-process inventory on hand. For example, if a company uses manufacturing resource planning (MRP), then it will create a forecast of expected production and “push” product through the manufacturing facility, which can result in excess quantities of finished goods inventory. However, if a company uses the just-in-time (JIT) manufacturing system, then it produces only if there are specific customer orders in hand (generally speaking), which “pulls” inventory through the facility only as needed, and tends to reduce the overall level of inventory.
- Overhead absorption problems. If the management team is compensated based on the level of company profits, it will be tempted to increase the level of inventory, even if there is no need for the excess amount. The reason for doing so is that overhead costs can be spread over more units of production, which keeps much of the overhead cost from being charged to the cost of goods sold, which in turn increases profits. However, the cost of doing so is that the company’s investment in inventory increases.
- Distribution problems. If a company has a distribution policy of having inventory as close to the customer as possible for rapid servicing issues, the result will be additional inventory. For example, if a company adds a local warehouse for every new sales territory that it creates, the company’s investment in inventory will be significantly greater.
- Sales growth. As company sales increase, so too will the inventory needed to support those sales. For example, if a retail chain increases sales by adding new stores, each new store must contain an adequate amount of inventory. Accordingly, inventory will increase in roughly the same proportion to sales as is currently the case, which will increase the company’s investment in inventory.
Working Capital Element#2: Accounts Payable
- Changes to new suppliers. If a company switches to a new supplier that requires short payment terms, the company’s access to free credit from that supplier will be reduced. If the supplier is a major one, or if there are many new suppliers, all of whom require rapid payment, then this source of funds will be significantly reduced.
- New terms with existing suppliers. If an existing supplier negotiates a shorter payment term from the company, the amount of funds available through accounts payable will be reduced. This circumstance may arise as a result of price negotiations in which the company trades off a shorter payment period for lower unit prices, or perhaps because the supplier has experienced excessively long payment periods from the company and is now tightening its credit.
- Usage of early payment discount terms. Another reason for a reduction in accounts payable is that the controller has decided to reduce expenses by taking as many early payment discounts as possible. When this happens, the overall level of expenses will drop, but the amount of available funds from suppliers will also decrease.
- Incorrect early payments. If the accounts payable staff is incorrectly managed, it is possible that some payments to suppliers will be made earlier than necessary, which will reduce the amount of funds available from suppliers.
The preceding list detailed 20 ways in which a company’s investment in working capital can increase—and these are only the most common reasons. When management asks a controller for advice regarding how to reduce the overall investment in working capital, it is extremely useful to know why it increased in the first place, because the answer (with the exception of sales growth) to the underlying reason is also the correct recommendation to make to management. For example, if the accounts receivable balance has increased due to poor credit granting systems, then the obvious recommendation is to improve those systems. Likewise, an increase in inventory that is attributable to a poor changeover system by the engineering staff to new products should be addressed by a recommendation to improve that system.
There are only two cases in which fixing the root cause may not be the best answer. One is when the accounts payable balance has decreased due to new payment terms from suppliers or the accounting staff ’s taking an early payment discount. In this case, it may be necessary to use the new suppliers with the shorter payment terms, perhaps because they offer the best unit prices or delivery reliability, while taking early payment discounts may result in a reduction in costs. When this happens, the cost reductions should outweigh the reduced supplier funding. The other case is when a company is growing so fast that the associated accounts receivable and inventory must inevitably rise alongside it. In this case, there may not be a reasonable method for reducing the working capital investment, besides a recommendation to keep tight control over all existing systems that have an impact on this investment. In these two cases, a company will have to find alternate sources of funding so that it can invest in a higher level of working capital.