The Four Steps of the Working Capital Management Process

Working capital management is determining the range of amounts for each of the current assets and liabilities that best balances risk and reward.

The key word in that definition is “balance.” Too high or too low of an amount can cause problems. Here’s a table that summarizes these issues for key working capital accounts.

The risk of poor working capital management is poor profits and/or bankruptcy. Poor profits either come from hard costs (e.g., late fees or interest expense) or opportunity costs (e.g., revenue from higher-yielding assets). The reward for good capital management is higher profits at an acceptable risk level.

Let’s look further into balancing risk and reward. I used a simple linear balance in the above image, but a better graph is the curve in the image below. In this image, I define reward as the return on investment.

The curve goes from low risk and reward in the lower left of the graph to high risk and high return in the upper right. The curve of the line is very important. At the lower right corner, small increases in risk greatly increase return. On the upper right, it takes large increases to make small increases in returns. Management must decide where to position the company on this curve. They may pick different points on the curve for different components of working capital. For example, a company may have easy credit standards, which leads to high credit losses, while at the same time keeping large cash balances because of a low tolerance for liquidity risk.

Overview of the Working Capital Management Process

Here’s the outline of how a company manages working capital:

• Management and/or the board of directors should explicitly define their risk tolerance based on the company’s strategy.
• That risk tolerance is then mapped to financial metrics.
• Those metrics are then monitored.
• When the amount of a metric falls outside of the acceptable range, management decides whether to temporarily allow this exception or take steps to bring the metric back into the acceptable range.

Let’s now dive into each of those steps

Defining the Risk Tolerance

Every company faces risks and decides how exposed they are to those risks. Weak companies don’t identify these risks and passively accept high exposure to those risks. It’s much better to identify the company’s risks and decide which risks can be mitigated at an acceptable cost.

For example, a major risk identified in the table was bankruptcy due to limited access to cash. The company may decide to set a minimum amount of cash on hand to mitigate this risk.

Mapping the Risk Tolerance to Metrics

Management has determined that a “minimum amount” of cash should always be on hand. Metrics and targets for those metrics define what “minimum amount” means. The metric may be a simple dollar amount. It may be a ratio (e.g., cash balances as a multiple of expenses). We will look at many working capital metrics later in this course. An example target would be cash on hand equal to three months of projected expenses.

I noted that we are often looking at keeping working capital accounts within an acceptable range. That means setting targets for both minimum and maximum amounts. The company may want to set the maximum it will keep in cash, with any short-term cash above that put in investments.

The targets for the metrics reflect multiple factors. They include

• The company’s risk tolerance: We’ve already touched on this. In this course, we explore how risk tolerance will impact the credit policy for receivables, when to pay invoices, and how much short-term debt to have.
• The company’s industry: Service companies have little inventory, manufacturers may have moderate amounts of inventory, and wholesalers have large amounts of inventory.
• The volatility of uncertainties: A company may be exposed to a lack of access to products from their suppliers or slow shipping times. Interest rates or inflation spikes can have large economic consequences.
• The company’s stage in the business life cycle: In later lessons, we will see how growth consumes cash before generating cash. A high-growth company in a dynamic industry will set different targets than a mature company in a stable industry.

Monitoring the Metrics

Reports don’t monitor metrics; people monitor metrics. Defining metrics includes determining the monitoring frequency and who will monitor the metric. Reports often show the past results of metrics. It takes a person to determine the implications of past results for future performance. The cash metric example I mentioned earlier may be within the acceptable range in the past, but the trend may indicate that cash balances will likely drop below the minimum acceptable level in the future. The person monitoring the metric must have the authority to take action to improve the metric or have a way to communicate the potential implications to those who can take action.

Working capital accounts reflect items that quickly and frequently change. Cash and inventory can rapidly build up or be depleted. Working capital metrics thus require frequent monitoring and quick communication of exceptions to metric targets.

Deciding Whether to Act on a Metric

A form of working capital management is deciding whether to take action when a metric has or will likely fall outside the targets. Management may decide that the exception to policy is temporary, so no action is needed. On the other hand, quick action may be needed to stop an alarming trend.

Not all working capital management is a reaction to metrics. It also includes identifying opportunities and how they might impact the metrics and targets. For example, a supplier may offer a large discount if the company purchases a large quantity of goods. Management must decide if this would increase profits or tie up cash that could be better used for something else.

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• Performance Management