April 7, 2017
A closer look at working capital could pay big dividends in cash flow and valuation
A new report on working capital management finds that many middle market businesses may be missing out on opportunities to boost business valuation and performance by being complacent with their cash flow, despite reporting high levels of satisfaction with how their resources are pooled.
The report by the National Center for the Middle Market surveys the attitudes of decision makers regarding their organization’s management of working capital, or the timeframe and manner in which it collects and divides resources. There are three main components to working capital: payables (what a business owes), receivables (also known as collections) and inventory.
“In the ordinary course of business, [working capital is] money that you have tied up doing the things you need to do,” says the center’s executive director, Thomas Stewart. “If I’ve billed you, and I haven’t gotten paid yet, that is my money that is tied up waiting while the check is in the mail.”
According to this report, three-quarters of respondents say they are either very or extremely satisfied with how their business manages its working capital. However, when the report benchmarked responses against financial performance for publicly traded middle market companies, it found the fastest-growing middle market companies were managing their working capital much better than their more modestly performing counterparts. Moreover, the lopsided advantages were consistent among companies across all industries and all of the tiers within the middle market.
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“That was stunning to us,” Stewart says. “We had two sets of data. One was the survey that said 75% [of respondents] were very or extremely satisfied, and then we had the benchmarking data from public companies that showed that on every one of these parameters, the differences between companies at the 25th percentile and companies at the 75th percentile … were two to four times [greater].”
The effects of working capital management on operations flexibility is outlined in an example provided by the report authors using a fictional company called Hypothetical Materials, which earns $100 million in annual revenue. If Hypothetical Materials was in the 25th percentile compared to its peers, the average wait time before getting paid would be more than seven months, or 225 days, and the company would have $61 million in revenue suspended in receivables at any given time.
At the same time, Hypothetical Materials pays its own bills in 121 days. This means cash is flowing out from the company at a rate much faster that it’s coming in, significantly reducing the opportunities for growth and reinvestment, and increasing the probability of a situation where the company must operate on credit to remain solvent.
If Hypothetical Materials was instead operating in the 75th percentile for working capital management, it would be getting paid in less than three months, and would only have approximately $32 million awaiting payment in receivables at any given time. Its accounts payable, meanwhile, would essentially double to 240 days. This allows the company to have much more cash on hand at a given time for future operations and investment.
“Most companies are unaware of how big of an opportunity they have to free up money,” Stewart says.
Granted, a leap from the 25th percentile to 75th is bound to have a pronounced impact on the bottom line, but the report also found that even edging working capital metrics by as little as a day in favorable directions can free up substantial amounts of cash baked into a longer revenue cycle. A one-day tweak to either accounts payables or receivables will unlock an extra $260,000, while nudging both buckets by a single day will boost liquidity by nearly $800,000.
Another of the report’s contributors, Jason Cagle, head of sales for treasury and payment solutions at SunTrust Bank, says he’s seen middle market businesses ignore opportunities to improve their working capital efficiency because they feel it’s immaterial to the majority of what they are about as a company.
“The great irony is that [working capital] is the center of the conversation,” Cagle says, noting that improvements in working capital are a crucial component of garnering maximum corporate valuation.
“All the private equity shops—it sounds really complex and sophisticated—[but] all they are really doing is looking at businesses … where they see inefficiencies or growth opportunities. They buy them, and then they bring in a really good operator to accelerate days receivable, extend days payable, and therefore improve free cash flow and drive up the enterprise value so they can flip it and make a buck,” he says.
Even for a middle market company not looking to optimize its valuation or aggressively reinvest capital earnings, ignoring opportunities to massage cash flow is quickly becoming akin to leaving money on the table, Cagle says. That’s because rising interest rates are allowing high-balance savings accounts to generate a marked return for the first time in recent memory.
“In a low-rate environment, nobody has this burning desire to sit on cash because they’re not getting paid anything in the way of interest,” Cagle says. “For the first time in 10 years, we’re truly moving into a rising-rate environment.”
Ultimately, the paper argues it is up to the owners and executives of middle market business to develop a culture of working capital efficiency within an organization. For many, that means caring about more than just the bills being paid. Instead of being attuned with traditional logic of writing off debt as fast as possible and building up large inventories, a concerted effort should be made to reverse this point of view. The longer a business’ repayment terms and the leaner its inventory, the more wealth it keeps at its disposal. Yet, because this goes against many tenets of personal finance, Cagle notes that many CFO-level decision makers are not incentivized to be proactive in these areas.
“There’s this massive institutional inertia to, ‘do things like we’ve always done it. Because if we take a risk and get it wrong, that’s bad for me. But if I do nothing, that’s good. I’m fine,’ ” he says.
The report includes suggestions for implementing best practices regarding working capital management within organizations. Some are a matter of routine—such as taking advantage of the full payment period for bills, drawing down overstocked inventory levels or switching to electronic payments for quicker receivables—while others are more focused on fostering a culture of working capital prioritization. Long-term recommendations include setting KPIs for payables, receivables and inventory, and looking outside the organization to benchmark company performance against data from similar publicly held companies. Also, since many middle market companies are vendors that sell to larger entities, Stewart recommends being hawkish with buyer payment terms.
“Some of these [large companies] put on some very tough terms on payment. Fight back,” he says.
Ultimately, there will need to be a sustained, coordinated effort within an organization to achieve improvement in working capital management. Fortunately, Stewart says, that’s where marketers may help by telling the story of strength and advantage that comes from being in control of working capital.
“Marketers tend to be more interested in spending money than saving money,” Stewart says, “but … I think a smart CFO could reach out to a smart marketing person and say, ‘How do we tell this story and get our employees fired up?’"
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