If «cash is king», then working capital is the queen – capital release measures

Management, particularly in growth companies, often have their sole focus on sales and accrued income. Tie-in of capital, whether the company has sufficient liquidity to meet its obligations on a running basis, and what capital release measures can be applied, does not come to focus before challenges are encountered.

Periods of growth often leads to enlarged demand of capital from amongst other build-up of inventory and accounts receivable. Many industries invoice its customers in arrears. Strong sales growth then amplifies liquidity strain through prepayment of costs.

Accrual earnings is not acceptable payment for the obligations owed to governments, employees, suppliers and others. In order to secure sufficient liquidity reserves you should monitor and manage capital allocation closely.

Optimizing the balance sheet

Financing, investments, working capital and cash management influences the liquidity situation of any company. These are areas, which this article will focus on. The company’s profitability, including revenues and costs, naturally affects liquidity. It is also essential to have liquidity forecasting routines put in place. However, this article excludes such circumstances.

Are you adequately financed?

A company is funded by equity and debt, or variations thereof. Regardless of funding composition, it is important that management is aware of its capital cost and utilizes this metric when making investment decisions. Capital costs should always be an important decision parameter in financing, investment and working capital decisions. Not all funding structures works equally well for all business models. It is important that the company’s financing facilitates for, and not hinders, the execution of its business plans.

To the extent that one can influence this, it is advantageous to match amortization and interest payments outside of peak periods of capital strain. Overdraft arrangements are sensible for similar purposes.

Cash management and guarantees

Depending on company size and complexity of the corporate structure, cash management setups can cause more or less significance for fluctuating liquidity needs. For groups with multiple legal entities cash pools can be favourable. This allows account participants, with differences in their (working) capital flows, to finance one another interchangeably without having to draw on costly external financing.

Some entities or bank accounts can for various reasons in some cases not be included in cash pools, which in turn can lead to “trapped cash” positions. Alternatives, for example, «sweeping” arrangements can then be advantageous. Other factors can cause “trapped cash” positions. For example, deposits- and tax accounts. The capital cost of tied-up reserves can in many instances exceed the alternative costs associated with bank or other guarantees.

Investment analysis

Different industries have different investment needs, but most businesses have some investments such as production tools, premises, IT, machinery and vehicles. To ensure that capital resources are utilized optimally, present value analyses should be carried out before investment decisions above a certain size are done.In some cases, operating leases make more sense than outright purchases. Lease-or-own assessments should however first be decided after assessing the expected leasing cost against cost of capital from a purchase.

“Capital costs should always be an important decision parameter in financing, investment and working capital decisions”

Cash conversion cycle

Customers’ payment terms, including advanced or payments in arrears and days of credit, drive working capital flows. Industries, where the standard is for arrear payments, will in periods of strong growth experience an increase of capital tie-up from increased accounts receivable. In some cases this can be decreased by tightening customer’s credit conditions. This is however a balancing act. More restrictive behaviour than the industry norm can ultimately result in weakening sales performance.

Figure 1 – Work flow process for capital release assessments

In order to reduce cash conversion time factoring solutions can be appropriate. This entails selling customer receivables to a financial institution on an ongoing basis. This way the company receives payment briefly after invoicing. Such arrangements can simultaneously free up internal resources from invoice administration. However, cost savings must be seen in relation to factor costs. Offering cash discounts to customers in order to entice prompt payments can also be a feasible route to achieve similar results. However, none of these solutions needs to be mutually exclusive. Optimization of customer payments should take place after first segmenting customers based on their importance, payment behaviour and assumed credit risk.

It is important to have good billing and debt collection routines. If there exist repeated delays and/or non-payments, there is a need for an experienced debt collection partner. There are various solutions to consider, for example, third-party collections, “forward flow” or “one off” sales of entire legacy portfolios of overdue claims.

Inventory a premise for sale or unnecessary capital tie-up?

Inventory build-up can create liquidity challenges. Very often, an extended inventory is a condition to maintain market position and a premise for sales. Concerns about delivering capacity must however continuously be weighed against its cost of capital. Analysis of turnover of individual product groups and an assessment of the overall stock size relative to comparable companies are relevant in making sound inventory decisions.

Effective inventory management, regular sale and disposal of obsolete goods, demanding quick and frequent deliveries from subcontractors are some ways to reduce capital tie-up.

Accounts payable – free financing?

Increasing the number of payment days towards suppliers to maximize utilization of supplier credits can be a beneficial financing form for the business. Still, pushing too hard on suppliers’ credit terms can be harmful on these relationships.

“Supply chain financing” or guarantees can be used to improve the climate of cooperation to key suppliers. Then you can rather use your market power more actively against others. Finance managers must have a proactive approach to opportunities and threats that exist in playing on payables financing.

Capital management – only when liquidity is bad?

Good cash management is not only sensible in order to avoid extreme situations such as illiquidity. Through systematic management of liquidity, improvements can be made to the financial result and return on capital employed. This is achieved by freeing up capital from activities with lower returns and rather allocate them to activities that are more appropriate. Freed-up capital can be used for new investments or dividends.

Good capital management is not synonymous with having lowest working capital base, but rather continuous optimal use of available means.

Our approach

Mimir Consulting has experience from a variety of industries. This allows us quickly come to grasp with different business models. Thus, we quickly get an overview of the company’s main capital tie-ins and can evaluate alternative solutions for your business.

We assist our clients with, e.g.:

  • Capital cost analysis
  • Funding strategies
  • Working capital analysis
  • Investment analysis and creating frameworks for investment decisions
  • Build liquidity forecasting routines
  • Identifying potential areas for improvement
  • Establish capital efficiency strategies
  • Assist in Request For Proposal (RFP) processes and negotiations
  • Implement change processes, define KPIs, monitor and control
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