Frequently Asked Question: From FinListics June/July Newsletter

The ABC's of Net Working Capital and Cash Operating Cycle

by Guillermo Bustamante, Director of Research at FinListics Solutions

To boost business returns, many companies focus on better managing Net Working Capital. But what is it? Net Working Capital is the difference between current assets and non-interest bearing current liabilities. The key operating drivers, which some of your solutions help clients better manage, are Accounts Receivables (A/R), Inventories, and Accounts Payable (A/P). For many companies, the investment in Net Working Capital represents 20-30% of operating assets. Note that while inventory is irrelevant for service companies and financial services like insurance, management of A/R and A/P remains crucial.

The Cash Operating Cycle expresses in days the time needed to sell inventory, collect from customers and pay suppliers.

Cash Operating Cycle = Days in Inventory + Days Sales Outstanding - Days Purchase Outstanding

The Cash Operating Cycle makes it easier to evaluate changes in a company’s performance over time and compared to its peers and industry. As a company grows, the amount of funds invested in A/R, Inventory and A/P typically increases. The Cash Operating Cycle also provides powerful insights into changes in managing these areas.

Typically, the lower the Cash Operating Cycle, the better. Why? Because this frees up funds to invest elsewhere. The goal from an executive’s perspective, however, is to manage the Cash Operating Cycle that maximizes overall financial performance. For example, a company could trim inventory, decreasing the cash operating cycle and funds invested in net working capital, but lose valuable sales because of stock outs.

Check out this example—and, for now, don’t worry about the calculations. We’ll explore the management of these areas in more detail in future newsletters.

Here, net working capital is $250 million. The cash operating cycle is 105 days, yet this number alone isn’t overly insightful. You must compare it over time and relative to other companies and the industry. Suppose the cash operating cycle over time has jumped from 80 to 105 days. You’ll want to consider these questions:

• Which components have most changed?
• Have there been modifications in the client’s product/service mix or business model requiring these changes?
• Do the changes indicate areas of opportunity for your solutions?
• Does the client have any initiatives underway to better manage its cash operating cycle?