Freeing cash flow
in your business
Executive summary
Your company is growing. Sales are skyrocketing, you’re taking on
new people and you’re looking at expanding. Business is booming
and everything’s in order. Right?
If you scratch below the surface, you may find everything is not
alright – in fact, some things may be very wrong.
When you are not sure if your next sale will result in increased cash
flow, you may be ‘growing broke’ and this publication is for you.
When things are looking good and you’re focused on taking your business to the next level, it can be easy to look at the big picture; but like so many things in life, the devil is in the detail.
When you consider growing your business, you’re most likely driven by the desire to increase your customer base, win market share and expand into new products and markets.
Ambitious growth strategies – in particular those which shift the attention from managing the here and now to focusing on the end result – can have unpleasant side effects.
These unforeseen consequences cannot only deprive a business of cash flow from a build up of inventories and accounts receivables, but also result in inefficient operational processes and sub-optimal capital management. This can lead to lower returns on assets, riskier capital structures, stress on dividends and depressed business valuations. With a diverse range of clients across a wide range of industries, our combined experience has taught us that private businesses must balance growth and profitability with actively managing working capital. The most successful companies manage not only the profit and loss statement, but also the balance sheet and working capital.
Working capital management (WCM) focuses on maintaining efficient levels of both current assets and current liabilities. It ensures a company has cash flow in order to meet its short-term debt obligations and operating expenses, which can be a particular challenge during periods of strong growth. Given the time it takes to recognise profit and generate positive cash flow, businesses undergoing rapid growth without a WCM system in place can be starved of funds.
By adopting a working capital
management system that
includes effective management
of debtors, procurement and
supply chain, a company can
improve earnings and cash flow.
WCM can benefit any business at any stage in its life cycle.Significant improvements in WCM should be a strategic focus of the finance function, as businesses often hold more working capital than necessary.
By implementing performance
improvement initiatives and
reducing working capital
intensity, the finance function
can have a direct link to
increasing the value of the
business.
This focus can shift the role of the finance team from a perceived cost centre to playing a vital strategic role in the business.
In order to achieve maximum savings from WCM programs, businesses must address the often hidden relationships and levers between different
components of working capital across the business.
For this to be successful WCM initiatives need the commitment and support of your leadership team.
This publication looks at:
• The benefits of efficient working capital management and the impact on business value. • A case study demonstrating the potential to release cash by reverse engineering
common working capital metrics.
• Identifying the main levers of inventory, receivables and payables balances. • Linking the operating elements of working capital to value creation. • Common indicators and trigger points to instigate a working capital review. • PwC’s WCM value proposition.
“ WCM can benefit any business
at any stage in its life cycle.”
Contents
There is a clear link
between working
capital management
and business value.
05
09
11
13
07
10
12
15
14
Working capital
management
How do I know if I have
a problem?
Using creditors to
improve cash flow
Freeing cash with
inventory
PwC’s working
capital services
Why do you need to
manage working
capital?
Releasing cash flow
through debtors
PwC Private Clients
Working capital management
Working capital management (WCM) is the art of minimising
cash absorbed in a businesses operating cycle.
The timing difference between recognising profit and generating positive cash flow can create cash flow or liquidity problems for a business. This can be the result of costs associated with acquiring and holding inventory as payment is required in advance of making a sale. If the sale is made on credit terms, it takes even more time to collect the cash. Depending on the industry, this cycle could take in excess of ninety days, meaning the business must fund this timing difference.
When working capital is expressed in terms of days it is commonly referred to as the operating cycle of the business, the cash conversion cycle or the cash-to-cash cycle (C2C). The C2C cycle of a business reflects the time in days it takes for a company to convert the purchase of inventory into sales and collect the cash.
The time lag from purchasing inventory to making a sale and finally collecting cash creates a timing difference between profit and cash flow.
The quantification of this timing difference is known as the working capital requirement of a business.
Day 1
Cashflow
Start
DPO
DIO
DSO
Day 30
- $100,000
Day 60
C2C
90 days
Day 120
$130,000
$100,000purchase inventory Payment for inventory due Inventory sold to customer for $130,000
Customer pays
• Days inventories outstanding (DIO) = average number of days that inventory is held.
• Days sales outstanding (DSO) = average number of days until a company is paid by its customers. • Days payables outstanding (DPO) =
average number of days until a company pays its suppliers.
In the above example, if an overdraft is used to fund working capital throughout the C2C cycle at 10% p.a, the $30,000 gross margin is reduced by finance costs of $2,500 or approximately 8.3% of gross margin.
The secret to unlocking cash
flow in the business can be
found in the operations of
the value chain.
Supply chain strategy SKU management Planning Volume forecasting Production and assembly Storage and logistics Packaging and shipping Sourcing Production scheduling
Procurement
Management
Revenue
Debtor
Management
Supply chain
Management
Sales strategyDSO
Pipeline management After Sales Service Sales offers Customer acceptance Contract admin processing Sales order processing Credit control Fulfilment Rebates & discounts Cash collections and control Purchasing strategy Tendering and bidding Negotiating and evaluation Contracting Planning and preparation Contract relationship management Settlement and cash management controls Suppliers evaluation WCM and C2C CycleOp
erat
ions/Logistic
s
Pro
cu
re
m
en
t
S
ale
s &
M
ark
etin
g
Debtors (DSO) Creditors (DPO) Inventory (DIO) WCM C2C CycleDPO
DIO
WCM and
C2C cycle
Once you view working
capital management as
a system, you can steer,
influence and manage the
drivers to free up cash.
Why do you need to manage
working capital?
Alignment with strategy
The C2C cycle can be analysed and viewed in light of a company’s strategy. A business that competes on price should have tight working capital policies and manage its inventory and receivables days with discipline. This includes short credit terms for customers and the willingness to accept stock-outs in order to avoid holding excess inventory. On the other hand, a niche player is more inclined to extend favourable credit terms to reflect a business model that charges higher prices to its customers.
The stage of maturity of an organisation will also have an impact on the working capital requirements of a business. Those that are experiencing fast growth, declining growth or financial distress due to a broken capital structure are most likely to face cash constraints and therefore require strict WCM.
Net working capital absorption
Net working capital (NWC) $
A
B
C
D
E
F
450m
400m
350m
300m
250m
200m
150m
100m
Optimal growth
Fast growth
Financial stress
Downsizing
Declining
growth
Sales $
20m
25m
30m
35m
40m
45m
The goal of working
capital management is
to optimise growth and
move from position C
to A as shown here.
“ Businesses that ‘grow broke’ typically
experience deteriorating cash,
working capital metrics and exhibit
a lack of accountability.”
Worked example
The interplay between working capital
absorption and value:
There is a clear link between WCM and value creation. Creating business value is all about generating returns that exceed the level of risk taken. Cash is said to be king, and shareholders value growth in their investment.
Therefore business value can be expressed as a function of three inputs; free cash flow, risk and growth.
Value = Free cash flow/(risk less growth)
Given the above valuation mechanic there are three general options available to management for increasing the value of a company:
1. Increase the cash flow available to debt and equity providers.
2. Lower risk for the same reward. 3. Increase the rate of growth.
Assume a company generates $100 in free cash flow and $110 in earnings before interest, tax, depreciation and amortisation (EBITDA). Risk as measured by the company’s cost of capital is 20 percent, and based on historical data the future growth rate is expected to be 3 percent per annum.
Using the valuation framework above, the company could be valued at $588.
$100 / (20% - 3%) =
$588 or 5.3 times EBITDA
Assume now the business makes improvements to the rate of working capital being absorbed into the business and generates $130 in free cash flow, with risk, growth and EBITDA remaining constant.
The valuation framework would produce a valuation of $765, calculated as:
$130 / (20% - 3%) =
$765 or 7 times EBITDA
In this example, management can increase a company’s value through operating efficiencies focused on working capital improvements.
Increased efficiencies will lower the capital invested in the company and therefore allow surplus cash to be distributed back to shareholders or reinvested in strategic initiatives.
It is worth noting that businesses with inefficient working capital management are often acquired at a discount.
Debtors in a business are
typically monitored and
managed using a profile of
ageing that segments the
balance based on the number
of days outstanding; being 30,
60, 90 and 120 days past due.
Days sales outstanding (DSO) is commonly calculated by the following formula: DSO= (Accounts receivable/sales) x days in period.
Worked example
Consider a private importing business that has annual sales of $100 million and an accounts receivables balance at year end of $15 million. DSO can be calculated as follows:
$15/$100 x 365 = 55 days of credit sales that are unpaid at the end of the period.
If the importing business was able to reduce the DSO from 55 days down to 44 days then the potential to free up cash can be calculated by reverse engineering the traditional DSO calculation as follows:
Potential to free cash (DSO) = (Sales/days in period x target collection terms) – accounts receivable balance
Potential to free cash (DSO) = ($100,000,000/365 x 44) – $15,000,000 = $2,945,205
In this example, collecting debts on average in 44 days
instead of 55 days would free up $2.9 million in cash,
which could be returned to shareholders or used to
retire debt.
Releasing cash flow
through debtors
Common mistakes
• No credit policy.• No reference checks. • No progress payments.
Creditors, like debtors are
typically monitored and
managed using a profile of
ageing that segments the
balance based on the number
of days outstanding; being 30,
60, 90 and 120 days past due.
Days payables outstanding (DPO) is commonly calculated by the following formula:
Days payables outstanding (DPO) = Accounts payable/cost of sales x days in period.
Worked example
Consider an importing business that has cost of goods sold of $40 million and an accounts payables balance at year end of $2 million.
DPO would be calculated as follows: $2/$40 x 365 = 18 days
If the importing business increased DPO by 12 days, representing 30 days credit terms, the potential to free up cash can be
calculated as follows:
Potential to free cash (DPO) = (cost of sales/days in period x target settlement terms) – existing accounts payable balance. Potential to free cash (DPO) = ($40,000,000/365 x 30) – $2,000,000 = $1,287,671
In this example, settling accounts payable in 30
days instead of 18 days would free up almost
$1.3 million in cash, which could be returned to
shareholders or used to retire debt.
However, it is worth noting that days to pay creditors often depends on working capital management philosophy. Some companies will deliberately defer settlement or stretch creditors to preserve cash. Other businesses may pay creditors quickly to achieve favourable return service and to maintain a reputation in the local markets in which they operate.
Using creditors to improve cash flow
Common mistakes
• Settling creditors too quickly. • Limited negotiation skills and
lack of focus on payment terms from buyers.
• Limited controls on the interface between vendor master files and online payment systems. • No centralised procurement
Depending on the industry,
inventory can be the largest
component of working capital
that ties cash up in a business.
If inventory is not turned
over regularly it incurs
overheads such as storage,
administration, handling and
insurance. It is also subject
to risk of damage, theft,
deterioration, obsolescence
and may even be perishable.
The amount of inventory held at any time depends on balancing the holding costs against the opportunity cost of stock outs. Therefore, deciding when an operation should replenish its inventory is a critical success factor. From our experience, many companies overstock simply by purchasing goods greater than historic usage patterns which leads to excess working capital.
Freeing cash with inventory
Worked example
Days inventories outstanding (DIO) is a commonly used key performance indicator and is calculated by the following formula:
DIO = inventory/cost of sales x days.
Consider an importing business that has cost of goods sold of $40 million, and stock on hand at year end of $8 million.
DIO would be calculated as follows:
$8/$40 x 365 = 73 days
If the importing business decreased the inventory days by 13, representing two months worth of stock, the potential to free up cash
can be calculated as follows:
Potential to free cash (DIO) = (cost of sales/ days in
period x target inventory days) – stock on hand.
Potential to free cash (DIO) = ($40,000,000/365 x
60) – $8,000,000 = $1,424,658
In this example, turning over inventory on average
in 60 days instead of 73 days would free up $1.4 million
in cash for the business.
From our experience many
companies overstock
simply by purchasing
goods greater than historic
usage, which drains cash.
“ Liquidity measures can be ‘fools
gold’ – traditional measures of
liquidity including current and
quick ratios can actually mask
systemic working capital issues.”
How do I know if I have a problem?
Poor working capital
management can result in
liquidity risk to a business –
it can cause the business to
be in a position where it is
unable to pay its debts as
and when they fall due.
Traditional measures of liquidity including current and quick ratios can actually mask systemic working capital issues.The current ratio as measured by the level of current assets compared to current liabilities has historically been accepted as being favourable when it exceeds a ratio of 2:1. However, this measurement can be misleading if the organisation has a poor record of collecting debts and/or has an accumulation of slow moving and obsolete inventory.
Common indicators and
triggers for a working
capital review
• The business is generating strong sales, but never seems to have enough money.
• The business has deteriorating cash, working capital metrics and exhibits a lack of accountability for managing the balance sheet. • The business is making profits, but
cash flow is tight.
• You are uncertain if the business can pay a dividend.
• You are not sure how much cash is available.
• You have difficulties in managing seasonal fluctuations.
• You find yourself regularly bumping up against credit limits.
• There is an inability to fund future capital expenditure needs from operations.
• You have invested in new systems, but your cash management performance hasn’t improved. • Your bankers are suggesting you
review your operations.
• You never know what your cash position is.
• You have large differences between profit and cash flow.
• You have large amounts of money tied up in inventories and/or debtors.
• Your bank overdraft and finance lines are drawn down.
• You are approaching or have breached bank covenants.
• You experience difficulty in raising additional capital.
• You are planning to sell the business in the future.
• You are experiencing high levels of working capital investment compared to sales revenue.
Release cash from
operations
Accounts receivable Inventory Accounts payable Sales CashPwC’s working capital services
What we do
We take a practical, operational approach to improving the value of your business at a personal level. Our approach goes further than just an analytical high level review; we will examine your operations to identify improvement opportunities to increase cash flow. Once we’ve worked with you to uncover how you can do this, our methodology has identified in excess of 200 best practice initiatives that can be implemented to generate tangible, measurable improvements in the management of working capital.
We don’t just measure performance, we improve it.
How we do it
Our approach to unlocking the benefits of working capital improvements is based on a best practice gap analysis to determine if there are opportunities to implement operational improvements.
We analyse existing business problems and develop tailored plans for
improvement by providing specialised, objective advice based on our knowledge and expertise in industry best practice.
Freeing up additional cash also gives
management more options, including:
• The increased ability to pay higher dividends.• The ability to pay down debt to reduce finance charges and increase net operating profit.
• Improved credit rating and increased capacity to borrow and service additional debt to fund future growth. • The ability to re-invest in the businesses through
additional capital expenditure and research and development.
• The ability to pass on savings to customers to improve competitiveness and increase market share.
• Creates flexibility and opportunity to achieve an optional capital structure for the business.
Typically our working
capital services
pay for themselves,
meaning a net gain
to the business.
Best practice is the most efficient and effective way of accomplishing a task, based on repeatable procedures that have proven themselves successful over time for large numbers of businesses. A procedure that meets best practice should achieve the best results with the least amount of effort.
Benefits
Increasing cash flow will
enable you to reduce the
capital intensity of your
business, allowing you to
increase the return or yield
the business generates.
Increasing free cash flow in the business will also make the business more valuable as measured by enterprise valuation models based on discounted cash flow techniques. This means the business will be worth more, allowing owners the opportunity to extract additional value on exit.
Are you growing broke?
Conclusion
The most successful companies apply the same discipline to capital management as
to managing the profit and loss account. They understand the C2C value chain along
with the working capital levers and actively address the root causes of tied-up cash.
By doing this they make the company more valuable for shareholders and more
attractive to debt providers.
Additional Debt +$60 Cost of Sales -$400 Operating Expenses -$300 Fixed Costs -$100 Tax -$63 Interest -$10 Dividends -$67 AR Days -$60 AP Days +$30 Inv Days -$90 $0
Growing broke –
next $1,000
of sales volume
After
additional
funding
$0
Additional revenue growth
$1,000
Gross
margin
$600
EBIT
$200
Retained
income $60
After
working
capital
$(-60)
The marginal cash flow represents the cash inflow generated from incremental revenue less the cash outflows to cover incremental variable cost of sales, incremental variable expenses and the incremental
investment in working capital.
In the above example, a fast expanding business is ‘growing broke’. An additional $1,000 of sales results in earnings, but after working capital absorption it experiences a $60 cash shortfall, which needs to be funded.
Private Clients Advisory – service offering
PwC Private Clients
PwC Private Clients uses it’s proprietary business improvement process to help private business
owners and individuals improve business performance and realise ambitions. Often the first
step to improve business performance is an assessment of financial health using PwC’s own
financial X-Ray
®management tool.
Making the invisible visible
PwC’s Financial X-Ray® can highlight the absorption (good or bad) of working capital in a business to isolate if there is a problem.
PwC’s Financial X-Ray® is a one-page overview of a businesses financial results that turns normal balance sheet and profit and loss data into meaningful financial management information.
Financial X-Ray® vital
signs report
The Financial X-Ray® vital signs report allows businesses to look at management performance, positive or adverse trends, funding decisions, the actual cash generated and other meaningful financial data, including marginal cash flow and working capital management.
Working capital metrics can be analysed and benchmarked against industry standards as well as management objectives. 1. Early stage Horizon Corporatisation Journey to sustained performance Identify and define markets 2. G row th sta ge Develop products and services
management system
3. M atu rity Develop D evel op M an ag e the b usin ess Develo p busin ess m od el op erat ing syst em s
Horizon 1 services (Definition of business potential)
• Commercialisation plans, R&D and grant assistance
• Commercial due diligence
• Market research and industry analysis
• Competitor analysis
• Customer and product research
• Business plan design and review
• Business case development
• Financial modelling
Horizon 3 services (Accelerate performance)
• Strategic review and due diligence
• Process improvement
• Risk management & governance
• Balanced and strategic scorecard design and implementation
• Financial improvement plans – X-Ray®
• Working capital improvement
• Cost reduction & restructuring
• Finance function effectiveness
• Customer,portfolio and margin analysis
• Cultural assessments and change management
Horizon 2 services (Roadmap) • Financial Health Assessment –
Financial X-Ray®
• Strategy design and strategic planning • Business model design and review • Activity based management and
value driver analysis
• Value and wealth creation plans • Organisational design and evaluation • Capabilities and resource
assessments
• Decision support analysis – what if Financial X-Ray® • Growth 100 day action plans
• Waste audits • Pre-lend reviews
Alister Berkeley
Director, Private Clients Sydney
Tel: (02) 8266 0022 Mob: 0415 757 492
Email: alister.berkeley@au.pwc.com
