Active working capital management secures liquidity through the effective use of available funds and offers great opportunities to increase existing values. A three-part blog series shows how a company's capital commitment and cash conversion cycle can be determined and which measures can be taken to affect these positively.
Part 1/3: Short-term capital commitment and cash conversion cycle as indicators for uncovering optimization potential in working capital
In the first part, the working capital (WC) and the cash conversion cycle (CCC) are being examined in more detail.
- The net working capital provides information about the short-term capital commitment of a company.
- The cash conversion cycle describes the duration between the first payment for the purchase of goods, through production, to the receipt of money by the customer for an order or a product.
- In order to determine the CCC and the period of capital commitment, the following KPIs must be taken into account: Days Sales Outstanding (DSO), Days Payable Outstanding (DPO) and Days Inventory Held (DIH).
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The net working capital provides information about the short-term capital commitment of a company
The net working capital is determined based on the sum of inventories and receivables less all short-term liabilities.
Net working capital = Inventories + receivables - short-term liabilities
If the net working capital is only considered in isolation, no absolute statement can be made about the liquidity of a company. However, it provides an indication of a company's potential solvency: If the net working capital is negative, this means that the current assets can be financed by the short-term liabilities.
A high net working capital might indicate an elevated short-term capital commitment. Possible causes may be e.g. a high stock of inventory or an increased number of receivables towards customers. In this case, the company's short-term liquidity position is reduced by the high net working capital. As a result, the liquidity term can be significantly shortened and the need for financing with debt or equity capital arise.
The consideration of net working capital is not suitable for comparing companies with one another. Depending on the business model, different levels of inventory are required, for example. The net working capital of a manufacturing company that stores inventories for production is usually higher than that of a software developer who does not need any inventories.
The Cash Conversion Cycle describes the time between the first payment for the purchase of goods, through production, to the receipt of money by the customer for a service or a product.
In order to make statements about how quickly investments in inventories reach the company as cash flow, the net working capital is measured in relation to the sales of a company. This is possible by determining the CCC. The CCC is the average number of days it takes for the company to convert capital outflows to purchase inventories into capital inflows from its trade accounts receivable. The CCC shows how long a company's capital remains tied up in its business. To calculate the CCC, it is necessary to determine the following three key figures:
In the following, the key figures are determined for the period of one year (365 days), but a monthly, weekly etc. view is also possible. In this case, the corresponding values are used in the formula and multiplied by the corresponding time value (x30 for days, x7 for weeks).
Days Sales Outstanding (DSO): The average duration of incoming payments for deliverables and performance in days (see Fig. 1).
DSO = (Average Receivables / Sales) x 365 days
Days Payable Outstanding (DPO): the average time in days until outstanding debts are settled (see Fig. 1).
DPO = (Average Trade Payables / Total Purchases) x 365 days
Days Inventory Held (DIH): The average number of days that inventories are in the company from goods receipt to sale (see Fig. 1).
DIH = (Average inventory / cost of materials - other operating expenses) x 365 days
In order to determine the CCC and the period of capital commitment, the following KPIs must be taken into account: Days Sales Outstanding (DSO), Days Payable Outstanding (DPO) and Days Inventory Held (DIH).
Based on the key figures as shown above, the CCC can now be calculated as follows:
CCC = DIH + DSO – DPO
The shorter the CCC, the less bridging funding a company needs as it takes fewer days to convert an inventory investment back into cash through sales.
Even with the CCC, there is no comparability between companies because the individual key figures differ depending on the business activity and can therefore lead to very different results. Within an industry, however, the CCC can be used as a benchmark for the efficiency of capital commitment.
In case the net working capital and cash conversion cycle indicate a high capital commitment, there might be a need for action taken in warehousing or the management of receivables and payables. Companies with comparable supply and value chains may be used as a benchmark.
Im nächsten Teil unserer Reihe zu Werthebeln im Working Capital Management beleuchten wir die einzelnen Kennzahlen des Cash Conversion Cycle näher. Außerdem zeigen wir Maßnahmen zur Optimierung des CCC sowie des Net Working Capital auf.
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