14.3 Working capital and liquidity management

In order to survive, an organization must be able to meet all its commitments as they fall due, i.e. to pay its bills on time. The efficient management of working capital, therefore, and particularly the provision of adequate levels of liquidity at all times, are crucial.

Definitions

Accountants define working capital in accounting terms as the difference between current assets and current liabilities. This is a static approach, and not a very useful one. Liquidity – the ability to meet commitments and to pay bills – comes from the availability of cash. A company could have considerable working capital in the accounting sense (because of very large inventories) but no cash, and thus be on the point of insolvency. The approach taken here will be based on cash flows rather than on accounting concepts. One of the most useful services the consultant can perform is to educate the client to think, and to plan, in cash-flow terms.

Working capital and the operating cycle

Every manufacturing business has an intrinsic operating cycle, in which materials are purchased, stocked, converted into finished products and finally sold. Even service industries have such a cycle, though its duration is shorter. Cash flows out of the organization when purchases are made, and returns when accounts receivable are collected. Consultants can help clients to understand their organization’s own unique operating cycle, and to find ways of increasing operating efficiency so that the cycle is shortened and cash is conserved. In most organizations, improvements of 25 to 40 per cent in cash utilization may often be made simply by careful analysis and the application of common sense.

One of the factors that the consultant should remember (and one of the advantages he or she has over the banker or the accountant) is that the changes leading to improvements in cash utilization are as likely to be in production or other operating areas as in purely financial ones. Improvements in inventory control leading to a reduction in average stock levels, and improvements in quality control that reduce wastage and scrap, will reduce the cash tied up in the operating cycle just as effectively as an improvement in collection of accounts receivable, or an acceleration in the transfer of funds from remote locations to a central concentration account. The very fact that most managers working in non-financial areas do not fully