Managing liquidity is among the top priorities for any finance department. Determining the appropriate inventory stock, optimal payment terms or how to set discounts on early payments can help to effectively manage your company’s cash position.

In this article, we’ll outline some key considerations and how Apliqo can help incorporate working capital management into the general finance planning process through scenario and sensitivity analysis

In today’s competitive business environment, effective financial management is crucial. One key area often overlooked is Net Working Capital (NWC). Understanding and optimizing NWC can unlock significant value and cash. This article explores how businesses can model their NWC and leverage improvements to enhance overall value.

What is Net Working Capital?

Net Working Capital is the difference between a company’s current assets and current liabilities. It is a measure of a company's operational efficiency and short-term financial health. A positive NWC indicates that a company can cover its short-term liabilities with its short-term assets, while a negative NWC suggests potential liquidity problems. The more NWC a company is holding; the more capital is bound to “work” for the operating business. Businesses are thus eager to optimize (or minimize) the level of NWC to increase the overall return on capital employed (or ROCE).

Why is Net Working Capital Important?

Net Working capital is important because it is necessary for businesses to remain solvent. In theory, a business could become bankrupt even if it is profitable. After all, a business cannot rely on paper profits to pay its bills—those bills need to be paid in cash readily in hand. So generally NWC is used for:

Liquidity Management: Ensuring sufficient liquidity to meet short-term obligations.

Operational Efficiency: Reflecting how well a company manages its receivables, payables, and inventory.

Investment Potential: Providing insights into the company’s ability to invest in growth opportunities.

Key Performance Indicators (KPIs) for Efficient Net Working Capital

To effectively manage and improve NWC, it’s essential to monitor specific KPIs:

Days Sales Outstanding (DSO)

• Measures the average number of days it takes to collect payment after a sale.

• Formula: DSO = (Accounts Receivable / Total Credit Sales) x Number of Days.

• Lower DSO indicates faster collection of receivables.

  
  

Days Inventory Outstanding (DII)

• Indicates the average number of days inventory is held before being sold.

• Formula: DII = (Inventory / Cost of Goods Sold) x Number of Days.

• Lower DII suggests efficient inventory management.

  
  

Days Payable Outstanding (DPO)

• Represents the average number of days a company takes to pay its suppliers.

• Formula: DPO = (Accounts Payable / Cost of Goods Sold) x Number of Days.

• Higher DPO can improve cash flow, but should be balanced to maintain supplier relationships.

  
  

Cash Conversion Cycle (CCC)

• Measures the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

• Formula: CCC = DSO + DII - DPO.

• Lower CCC indicates a shorter duration to free up cash from operations.

But all of the above KPIs only tell one side of the story unless put into context comparing it with industry peers and understanding the company’s strategy. As an example, a company may proactively decide to hold more inventory compared to its peers so they are able to deliver more product or always have stock-on-hand. On the other hand, another company may decide not to hold any or very little inventory as they have a very sophisticated supply chain leveraging just-in-time delivery.

Practical Example: Impact of Reducing CCC 

Consider a company with a base NWC of $12 million and an initial CCC of 60 days. If the company manages to reduce its CCC by 5 days, from 60 to 55 days, this improvement can have a significant impact on cash flow.

1. Current CCC: 60 days

2. Target CCC: 55 days

3. Reduction: 5 days

   
   

To quantify the impact, we calculate the daily cash flow impact. Assuming a constant sales rate, we can use the following approach:

• Annual Sales: $100 million

• Daily Sales: $100 million / 365 days ≈ $273,973

• Reduction in CCC: 5 days

  
  

Impact on Cash Flow:

• Daily Cash Flow Impact = Daily Sales x Reduction in CCC

• Daily Cash Flow Impact = $273,973 x 5 ≈ $1.37 million

  
  

So, reducing the CCC by 5 days would free up approximately $1.37 million in cash flow, improving the company’s liquidity and financial flexibility.

Strategies to Improve Net Working Capital

Improving NWC involves optimizing the components of current assets and liabilities. Here are some strategies:

Improve Receivables Collection:

• Implement efficient invoicing and follow-up processes.

• Offer discounts for early payments to encourage quicker collections.

  
  

Optimize Inventory Management:

• Use just-in-time (JIT) inventory systems to reduce excess stock.

• Employ inventory forecasting techniques to align stock levels with demand.

Extend Payables Without Harming Relationships:

• Negotiate better payment terms with suppliers.

• Use trade credit effectively to delay cash outflows.

Enhance Cash Management:

• Maintain an optimal cash balance to cover short-term needs.

• Invest surplus cash in short-term, liquid instruments.

Leveraging FP&A Software for NWC Improvement

Financial Planning and Analysis (FP&A) software such as Apliqo FPM play a critical role in supporting initiatives to improve Net Working Capital. Here's how:

Data Integration and Real-Time Analysis

• FP&A software integrates data from various departments, providing a holistic view of current assets and liabilities.

• Real-time analysis allows companies to monitor NWC metrics continuously and react swiftly to changes.

• KPIs (ie. DSO, DII, DPO, CCC) can be calculated and reported in real-time on large datasets, including the ability to present it in multi-dimensional way by all business relevant dimensions and structures

  
  

Advanced Forecasting and Scenario Planning

• The software enables detailed forecasting and scenario analysis, helping businesses predict the impact of different strategies on NWC.

• This predictive capability allows for proactive adjustments, ensuring optimal NWC management.

• Predictive (machine-learning based) algorithms can be used to provide automated forecasts allowing to capital utilization

  
  

Automated Reporting

Automated reporting features streamline the process of generating financial reports, reducing manual errors and saving time.

This accuracy and efficiency in reporting enhance decision-making processes related to NWC.

Cash Flow Management Tools

• FP&A tools offer sophisticated cash flow management features, helping companies maintain optimal liquidity levels.

• By accurately forecasting cash inflows and outflows, businesses can better manage their working capital needs.

Performance Benchmarking

• The software can benchmark a company's performance against industry standards, providing insights into areas needing improvement.

• This benchmarking is crucial for setting realistic NWC improvement targets.

Net Working Capital Module

The Net Working Capital module is part of the Apliqo FPM suite and in essence allows you to discern transactional data directly from e.g. S/4 Hanna to obtain an unfiltered truth about your working capital position. The module consists of the following parts:

Payables

• Purchase order (PO) analysis: Understand what purchases get executed without any purchase order. Examine the price effect of these and create scenarios where you eliminate expensive ad-hoc purchases.

• Payment term days: Understand what payment term days are prevalent and how you can model the effect on your three-way financial model if you align them more favorably.

• AP ageing: Analyze the tradeoff between market borrowing rates and discounts for early payment (or fees for late payments) to optimize payment behavior with respect to market interest rates.

Receivables

• Payment term analysis: Similar to AP terms, understand where you could potentially adjust your payment terms to free up cash.

• Days to collect: Discern your customer payment behavior and examine through sensitivity analysis if discounts for early payments could improve your cash collection favorably.

• Credit notes: Understand the effect of faulty invoices and what the effect would be on your working capital if you were able to reduce or even eliminate them.

  
  

Inventory

• Starting from cycle and safety stock, understand possible excess or under stock situations and how they could exert unduly pressure on your liquidity.

  
  

Sales taxes (VAT)

• Understand the effect sales taxes have on your liquidity. If, for example, the payment from a certain customer has not been received by the VAT payment due date, you are effectively facing a cash outflow for a sale.

  
  

Driver-based input

One of the main advantages of Apliqo FPM is that the working capital analysis can be leveraged in a bottom-up fashion as an input for the general forecasting and planning process. For example, instead of the purchasing manager manually entering their estimates, Apliqo’s driver-based methodology allows you to directly incorporate different scenarios from the working capital module into your planning. This enables you to model the effect of working capital scenarios on the income statement, balance sheet, and cash flow by selecting and configuring the appropriate driver.

The following scenarios are examples of drivers that can be selected for your working capital positions:

• Use sales orders to lock in a 13-week forecast. Combining the 13-week forecast with a time-series analysis of historical conversion rates of sales orders to actual sales produces a reliable forecast even beyond the 13-week period.

• Align your DSO, DPO, DIO to industry benchmarks and adjust them, if required, by a given percentage to reflect efficiency gains.

• Leverage sensitivity analysis to harmonize discounts for early payments: Mimicking the payment behavior of clients with similar characteristics and a given discount strategy already in place, you can estimate the effect of discounts and simulate the change in payment behavior.

The Role of Net Working Capital in M&A Transactions 

Net Working Capital plays a critical role in mergers and acquisitions (M&A) transactions, particularly in the Share Purchase Agreement (SPA) through mechanisms like the locked-box approach. Here’s how it works:

Locked-Box Mechanism

In M&A transactions, the locked-box mechanism is a method used to determine the purchase price based on the target company's balance sheet at a specific date (the locked-box date). From this date onwards, any cash generated by the target company until the closing date is effectively for the benefit of the buyer.

Importance of NWC in Locked-Box Mechanism

Valuation Adjustment

• The locked-box mechanism relies heavily on the NWC to ensure that any value changes from the locked-box date to the closing date are accurately reflected.

• NWC adjustments are often made to account for deviations in working capital levels, ensuring a fair purchase price.

Preventing Value Leakage

• Accurate NWC modeling ensures that there is no leakage of value between the locked-box date and the closing date.

• This means any changes in working capital that could affect the company's value are closely monitored and adjusted for in the final purchase price.

Ensuring Fair Transaction

• Properly adjusted NWC ensures that both the buyer and the seller agree on a fair transaction value.

• This mitigates the risk of disputes post-closing and ensures a smoother transition.

Generating Value Through Improved Net Working Capital

Enhancing NWC can generate substantial value for companies in several ways:

Increased Liquidity

Improved cash flow management enhances liquidity, allowing for better handling of unexpected expenses and investment opportunities.

Cost Savings

Reducing interest costs on short-term debt and optimizing inventory levels can lead to significant savings.

Enhanced Creditworthiness

A healthy NWC position can improve credit ratings, enabling access to better financing options.

Operational Flexibility

Efficient NWC management provides the flexibility to respond swiftly to market changes and invest in growth initiatives.

Conclusion

Modeling and improving Net Working Capital is not just a financial exercise but a strategic imperative. By focusing on key components like receivables, payables, and inventory, companies can enhance their liquidity, reduce costs, and ultimately generate greater value. Effective NWC management is a powerful lever for sustaining operational efficiency and driving business growth.

Investing time and resources in understanding and optimizing NWC can yield significant returns, positioning companies for long-term success in a dynamic business landscape. With the aid of FP&A software such as Apliqo FPM, businesses can achieve precise, real-time insights and make informed decisions that drive value. If you want to learn more about how our solutions can help you unlock value in your Net Working Capital, reach out to us.