Be Liquid and Profitable — July 2017

This topic involves Treasury. A key element of a firm’s liquidity and profitability is its working capital (current assets minus current liabilities). Converting accounts receivable and inventory to cash provides liquidity for paying creditors, investing in growth opportunities, and distributing cash to shareholders. The quicker this conversion occurs the greater the company’s return on invested capital, in our view the most important measure of the firm’s profitability. The CFO oversees several working capital functions that determine the company’s liquidity and profitability.
To provide the firm with sufficient liquidity while enhancing returns, the CFO must manage several tasks. These include: determine and execute the firm’s working capital strategy; optimize the cash conversion cycle; determine the appropriate short term investment vehicles; and manage the firm’s short borrowing efforts. Once these determinations are made the CFO must ensure that they are effectively executed. This can be challenging due to many tradeoffs that are extant in a company’s operations.
There are three working capital strategies the firm can pursue. The first, maturity matching, entails financing current assets with short term borrowing such as a bank line of credit. Long term assets such as equipment and vehicles are financed with long term borrowing such as bank term loans. Large projects, like new facilities, are financed with both long term financing and equity investments. We believe this is the most common working capital strategy.
A conservative working capital strategy utilizes long term debt to fund a portion of current assets. This strategy sacrifices potential profit increases for safety. An aggressive working capital strategy entails utilizing short term borrowing for a portion of the company’s long term assets. This strategy sacrifices safety for larger potential profit and is often pursued by banks and non-bank lenders as well as firms with an appetite for risk.
The cash conversion cycle is the amount of time the firm’s funds are tied up in working capital. The CFO’s goal is to reduce the cash conversion cycle without damaging supplier relationship, incurring stock outs, and losing sales. The cash conversion cycle consists of the purchase of inventory, payment for that inventory, sale of the product, and the collection of payment from the buyer of the product. (Please see our other articles on the cash conversion in the financial management category tab in topics of interest).
There are three ways to reduce the duration of the cash conversion cycle. The first is to manage accounts receivable so that collections are accelerated. This can be accomplished by more efficient and faster invoice processing, more restrictive credit policies, aggressive collection policies, and offering discounts as a reward for quicker payment.
The second way is to increase inventory turnover (conversely, reducing the number of days cash is tied up in inventory). This can be accomplished by using just in time inventory where the inventory is purchased as close as possible to the shipping date for the customer’s order. Also beneficial is implementation of proven techniques such as LEAN and Six Sigma which involve better planning and scheduling of production, matching production to demand rather than producing a pre-determined amount of inventory to reduce per unit costs, and measuring the tasks required to produce the inventory and minimizing the duration of these tasks without sacrificing effectiveness..
The third way is to lengthen the payment time for accounts payable. This is typically achieved by paying bills on the due date and maximizing payment float. The latter can be accomplished by zero balance accounts whereby the bank account is funded based on what is known will be disbursed the next day.
Since keeping cash in a bank account earns a tiny return, the CFO must investigate utilizing short term investments which are as liquid as a bank account, but earn a better return for the company. The vehicles for a short term investment strategy typically are: Treasury Securities, Repurchase agreements (REPOs), and commercial paper. Money market funds can also be utilized, but often require a management fee.
In our experience, more often than not, current assets are financed by short term debt. The CFO must find adequate and reliable sources of short term financing that meet the operating needs of the company. Important considerations include the ease of borrowing the money, minimal covenants, and cost considerations.
With regard to the cost, the CFO must find the most competitive all-in-cost. The key factors to consider are upfront fees, interest rate, and commitment fees. We suggest the CFO utilize a financial model (Excel is sufficient) to compare the all-in-cost of different lenders by calculating the all-in-costs for each under best case, worst case, and most likely case scenarios.
Short term financing is typically less costly than long term financing. In addition it is more flexible as it can be paid off at any time and matched with seasonal working capital needs. On the other hand, short term interest rates are variable and difficult to lock in, making future interest costs less certain. Furthermore, there is rollover risk which means the lender is unwilling to extend the loan term if a company’s cash flow is insufficient to pay off the loan at its due date.
Most successful small businesses have access to several desirable sources of funds. These include bank credit lines, letters of credit, commercial paper, securitization of receivables, and discounting receivables with a bank. However, some small businesses may not be judged creditworthy for such sources. In that case, alternatives include non-bank lenders like finance companies, business development companies, specialty lenders that usually take collateral valued at more than the amount of the loan, and factoring firms. These alternatives enable the firm to finance its assets, but are also more expensive and cumbersome than traditional means.
A key element of a firm’s liquidity and profitability is its working capital (current assets minus current liabilities). Converting accounts receivable and inventory to cash provides liquidity for paying creditors, investing in growth opportunities, and distributing cash to shareholders. The quicker this conversion occurs the more the company’s return on invested capital, in our view the most important measure of the firm’s profitability, is enhanced. The CFO oversees several working capital functions that determine the company’s liquidity and profitability.

Capitol CFO Solutions serves customers in Washington, D.C., Maryland, and Virginia. Please contact us for a free consultation.