Working capital efficiency is a measure of how well a company balances money it is owed by customers on sales and money invested in inventoried goods against money it owes for acquiring the inventory. This relationship of paying for goods, owing for goods and waiting to be paid for goods is called the cash conversion cycle. The more efficient a company is at navigating the cash conversion cycle, the higher is its level of working capital efficiency.
Almost all businesses must have cash on hand to fund short-term liquidity needs. This cash on hand is known as working capital. The amount of working capital a business has in relation to the need for it will affect the firm’s creditworthiness in the eyes of lenders and, if it is a public company, affect investors’ opinions of the company’s financial health. If a company’s working capital efficiency is high, that is if its business practices minimize the need for borrowed funds for short-term operational needs, it can make it easier for the business to borrow when necessary.
Businesses with large investments in permanent assets or firms that primarily provide services have less need for working capital than others. Working capital efficiency becomes very important for businesses such as retailers who must acquire an inventory of goods, owe vendors for that inventory and then are owed by customers who purchase the goods. This is particularly an issue for seasonal retailers who must invest heavily in inventory well in advance of their strongest sales season and yet might not be paid by customers for a matter of months.
Determining a company’s working capital efficiency begins with measuring its cash conversion cycle. This is a matter of adding the average number of days between putting a product in inventory and selling it to the average number of days after a product is sold until payment for the sale is collected. From that, the firm subtracts the average number of days between acquiring a product to paying for it. That figure is the company’s cash conversion cycle.
Typically the higher the cash conversion cycle, that is the higher the average number of days to convert inventory to sales less the average number of days to pay cost of the sales, the lower the business’ working capital efficiency rating. This represents a cost to the business, as working capital is either equity in the company that cannot be put to other uses if the firm is inefficient or it is debt, which is more costly the longer it is owed. For almost every business, a goal is to encourage managers at every step of the sales process to operate with a view toward efficient use of the capital. The less time goods are in inventory, the faster payments for sales are collected — the longer payments to vendors can be delayed, the better.