Jonas Schoefer

There is strategy, and there is operational efficiency. Both can make or break a company's financial performance and its returns to investors. A company's success in managing its working capital is one of the more telling indicators of operational efficiency.

Efficient working capital management can improve cash generation, funding capacity and financial structure. When working capital management is weak or deteriorates, all of these may suffer. For some types of companies, such as those in the construction or distribution sectors, working capital is at the heart of the business.

Where management of working capital has been weak or has slipped, improving it can offer great opportunity for enhancing cash generation.

REL, a global firm that specialises in advising companies on working capital, has analysed financial accounts of 160 of SA's largest public companies and found they have more than R177bn in excess working capital.

As with most financial ratios, it can be misleading to consider working capital figures in isolation. Many companies hold cash or inventories in foreign currencies. Or, along with the cash, they may have large borrowings at low interest rates.

Nonetheless, some trends are clear. Many companies responded to the economic downturn in 2009 by slashing capex and operating costs, and tightening working capital management. But few have generated sustainable long-term improvements in working capital performance, says Jonas Schoefer, REL director for SA.

As business conditions improved or stabilised, leading to renewed growth in sales volumes, the tight reins kept on the main elements of working capital - stock, debtors cash and creditors - have tended to loosen.

The same has occurred in the US. A similar survey carried out by REL covering 1000 large US companies found they were only marginally more efficient than in the previous year, and that their excess working capital was the highest in five years.

The REL surveys apply several key measures of working capital. Among the most important is DWC, or days working capital. It measures the average number of days of working capital tied up in the operating cycle. It's defined as net working capital (stock plus receivables less payables) divided by annual sales multiplied by 365 (see table). The number of days should be low, or declining.

CCE, or the cash conversion efficiency ratio, shows a company's efficiency at generating free cash flow from operations, or operating cash flow from sales revenue. It's calculated by dividing cash from operations by annual sales. Most of the companies in the table that improved their days working capital also improved their cash conversion efficiency.

The SA survey, based mainly on 2011 annual reports, found an overall improvement in working capital. The companies that were covered increased their revenues by 9,6% and their net working capital by only 6,1%. But the improvement in days working capital was marginal, at 1,3 days, and it came mostly through changes in outstanding payables.

The survey found large opportunities for improvement in areas such as stock control and receivables (the amounts owed by customers).

Working capital performance is just one of the things that influence profitability measures such as operating margins and returns on capital. Others include sales volumes, product prices and cost controls. But Schoefer says improvement in days working capital is often accompanied by better margins or returns on capital, and it can help compensate for constraints in other areas.

Considering its importance, why don't more companies sustain tighter management of working capital?

Schoefer says there is a common underlying theme. In many companies the most important "key performance indicator" or KPI, for management is earnings before interest and tax (Ebit), which doesn't explicitly take working capital into account. Ebit can be "tweaked" by letting working capital slip.

At an industry level, food product companies were among the best performers. Some of their results demonstrate the correlation between working capital, operating efficiency and financial performance.

AVI's revenue grew by 5,7%, but the company cut its days working capital by 5,7% to 60,2 days. Chairman Angus Band (recently retired) said in his review that working capital was "well controlled", with the year-end net balance slightly lower than a year earlier. The operating margin rose sharply and cash generated by operations increased by almost 24%.

Sovereign Foods, a poultry producer, reduced its days working capital by 48%, to 17,9 days. That, with increased production volumes, helped compensate for an average 5% drop in its product prices due to a market oversupply. It maintained its margins and strongly increased cash generation.

Fishing company Oceana reduced its days working capital in its 2011 financial year by 20,7%, to 71,9 days. Financial director Rod Nicol said net investment income increased because of higher cash balances that resulted from lower working capital requirements. The results for the year to September 2012 showed higher margins and sharply improved earnings, though investment in the international supply chain increased the working capital requirement.

In the food retailing sector, Spar cut its days working capital by 20,1%, to 11,8 days. That helped produce a R582m increase in cash from operations.

Stronger cash generation and liquidity are among the biggest benefits of sustained improvement in working capital management. As Schoefer says, when companies have the cash, they can do so much with it, including investment in strategic assets. But weak or inconsistent working capital management can erode cash flow and earnings, and may heighten the risks when business conditions deteriorate.