Working Capital Management for Corporate Treasurers

Introduction to Working Capital Management

Funding is one of the most important treasury activities for companies.

Ensuring that the company has enough funds is critical for the corporate treasurer, especially during periods of market volatility and uncertainty, like the recent global financial crisis.

For long-term funding (more than 1 year), treasurers would normally consider debt or equity issuance. As for short-term funding (less than 1 year), treasurers can turn to shorter-term markets or money markets like repos, interbank lending, commercial paper, fed funds, etc.

However, sometimes, in a liquidity crisis, the company may not be able to access money from the capital markets to meet its liability payments when they are due. 

Therefore, it is important for the treasurer not just to consider external sources of funding. Today, many CFOs and treasurers today are also looking internally within the organization to see if there are ways to unlock cash that is trapped in working capital, i.e. optimize working capital for the company.

To understand how good working capital management could potentially unlock considerable amount of cash for a company, we will first need to understand the concept of the cash conversion cycle


What is Working Capital?

Working capital refers to a company’s current assets minus its current liabilities.

Working capital management refers to the management of short-term financing of a company, including cash, inventory, accounts receivable, accounts payable, short-term loans, etc., to ensure adequate cash flow for operations and most productive use of a company’s resources.

Working capital is affected by various business functions - sales, production, procurement… Therefore, before we discuss how to optimize working capital, first of all we need to understand the typical sales and purchases process of a company.

The typical sales and purchases process for most companies goes like this:

  • Step #1: Company purchases inventory on credit. Inventory is stored in warehouse.
  • Step #2: Company receives AP invoice and pays suppliers when AP invoice is due.
  • Step #3: Company sells inventory on credit, and issues AR invoice to customer.
  • Step #4: Company receives cash from customer when AR invoice is due.

To optimize working capital for the company, we need to ask ourselves this question:

How do we improve the sales and purchases process so that we can optimize our working capital?

To answer this question, we need to look at the cash conversion cycle to understand the amount of time it takes for a company’s investment in inventory to generate cash.


What is the cash conversion cycle?

Cash conversion cycle =

Number of days of inventory (DIO) +

Number of days of receivables or Days of Sales Outstanding (DSO) –

Number of days of payables or Days of Purchases Outstanding (DPO)

In short, a company’s cash conversion cycle depends on 3 main factors:

  • The average time company takes to pay its suppliers, i.e. Number of days of payable or days inventory outstanding
  • The average time company takes to collect on accounts receivable, i.e. Number of days of receivables or days receivable outstanding
  • The average time company takes to create and sell inventory, i.e. Number of days of inventory or days payables outstanding


Optimization of Cash Conversion Cycle

To optimize the cash conversion cycle, i.e. minimize the amount of time it takes to generate cash for the company, the company should extend the days payable outstanding (DPO) and reduce the days receivable outstanding (DSO) and days inventory outstanding (DIO).

While having a short cash conversion cycle is good, the treasurer or CFO should not look too simplistically at the numbers behind the cash conversion cycle. Why is that so?

If the number of days inventory outstanding is high, it could be due to a deliberate policy by the company to buy in bulk to save costs.

Similarly, the number of days receivable outstanding could be high due to various reasons like special discounts to boost sales.

So, how do treasurers manage the company’s working capital to optimize the cash conversion cycle? In the section below, we will introduce 3 main tools commonly used by treasurers for working capital management.

Tool #1: Managing Receivables

This is normally the hardest part of working capital management, because most of the time it is not easy to control payment behavior of customers.

  • Reduce invoicing delays and errors. Sometimes, collection of cash from AR invoices is delayed due to internal invoicing delays and errors by the accounting department. If so, the company should look internally to see how such delays and errors can be minimized. This could mean improving the bank account reconciliation processes by improving timeliness of remittance advices from the banks or setting up auto-reconciliation processes through system implementations. Different banks do offer various solutions (e.g. virtual accounts) to help companies with their reconciliation processes.
  • Improve collections from overdue customers. Customers may delay payments due to different reasons. The collections team may need to remind customers with overdue invoices to make timely payments through ‘friendly’ calls. An attorney’s letter or on-site visit may be required for more severe cases. Although untimely payments from customers may sometimes be difficult to control due to the need to maintain good customer relationships, the treasurer should monitor the company’s ageing AR report to ensure that the number of overdue AR invoices is kept to a minimum.
  • Ensure proper credit management of customers. When the company extends credit to its customers, the treasurer should consider the credit rating or probability of default of its customers. For large projects, it would be wise to request for guarantees from a corporate parent or a letter of credit from a bank.


Tool #2: Managing Inventory

  • Minimize the required safety stock level. Although the inventory management process is not under the control of the treasurer, the treasurer needs to understand the factors affecting inventory management as they have an impact on the working capital and cash conversion cycle of the company. Companies normally have to maintain a minimum required safety stock level as a buffer. The amount of safety stock level typically depends on the delivery and supplier lead times. If the company can reduce the lead times, the minimum required safety stock level can be reduced, which will in turn improve the inventory turnover and shorten the cash conversion cycle.
  • Reduce inventory forecasting errors. The company normally orders inventory based on forecasts of future orders. If the company is able to forecast orders more accurately, for example by having access to inventory planning systems of key customers, it will be able to reduce its inventory forecasting error.
  • Reduce work in process (WIP) inventory. Traditional manufacturing processes may have long production runs to reduce the fixed cost per manufactured unit, but this often results in a build-up of excessive inventory levels. Some companies have switched to a Just-in-time (JIT) manufacturing system, where manufacturing is only triggered when an order is placed. In such a system, there will never be excessive inventory on hand.


Tool #3: Managing Payables

  • Extend payment terms. Having extended credit is beneficial to the company’s cash conversion cycle. This may not always be possible, and depends on the size and bargaining power of the company over its suppliers. Large suppliers may sometimes request for short payment terms or even require companies to make advance payments for large projects, which will reduce the amount of cash flows from working capital available for the company.
  • Payment processing policies. A company may decide to make early repayments to take advantage of early repayment discounts. However, this may not always be ideal for the company if cash flows are very tight, and this may affect the short-term funding of the company.
  • Improve payment efficiency through intercompany netting. Intercompany netting involves offsetting receivables against payables among affiliated companies. If a company has many intercompany flows, it is more efficient to net the intercompany flows, so that actual cash flows between related companies are minimized. Implementing intercompany netting will make payment processing more efficient for the group overall and reduce the liquidity requirements of individual entities.
  • Supply chain financing is another useful tool used by corporate treasurers for payment management to free up valuable working capital and liquidity in the supply chain. Under supply chain financing, the company sends its payable list, which will include the supplier information, amounts payable, and invoice due dates, electronically to the bank. The bank will offer to make early repayment to the company’s suppliers, in exchange for a financing charge. On the invoice due dates, the bank will finally collect payment from the company. (see diagram below for illustration)


Example taken from DBS website

We hope this provides a clear summary of how a corporate treasurer might look at working capital issues, and the various ways treasurers can improve working capital management by optimizing their cash conversion cycle.

Next, read this article to learn about efficient cash management - how corporate treasurers manage cash efficiently from multiple entities and bank accounts.