From the March 2012 issue of Treasury & Risk magazine

The Case for Working Capital

Shareholders don’t seem to care, but a strategic approach to working capital management brings other benefits, says Gregory Milano of Fortuna Advisors.

Over the last few decades, companies sharpened their focus on delivering desirable returns to shareholders and embraced some form of return on capital, economic profit or a comparable performance measure. This focus on high returns led companies to scrutinize not just their capital investments, but their use of net operating working capital as well. Net operating working capital consists primarily of inventory and accounts receivable less accounts payable and accrued expenses. Cash balances are often excluded, although it could be argued that some balance of cash is required to run operations. Short-term debt and debt equivalents are also excluded as these are sources of capital provided by entities that expect a return on their investment.

T&R: How can working capital management be improved?
Milano: Companies improve working capital efficiency by reducing inventory levels using better management techniques such as just-in-time, lean manufacturing and process reengineering. Invoicing systems, payment clauses in contracts, tighter credit scrutiny and improved collections have reduced accounts receivable. And many adopt accounts payable practices designed to pay vendors on the last possible day to take advantage of supplier capital. Indeed for many companies, reducing the investment in working capital has become a way of life.

Perhaps a better way to examine this data is to normalize the level of working capital based on some measure of profit or cash flow instead of revenue, so we can adjust for the differences in profitability. To test this, we determined an alternative DOH measure based on days of EBITDA, or earnings before interest, tax, depreciation and amortization. What appears to be a large working capital balance when compared to revenue may not seem so large when compared to EBITDA in a highly profitable company.

Although this makes logical sense, the results are less favorable. The quartile of companies with more efficient net operating working capital based on days of EBITDA delivered 6.1% lower TSR than the least efficient quartile.

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