Finance for Procurement Professionals – Working Capital

In this, another in our occasional series looking at what procurement professionals need to know about finance, we’ll take a look at working capital. This is, in basic terms, the money, liquidity or funds that are available to run the business, calculated as current assets minus current liabilities.

Now one critical factor to understand is that firms can go bust whilst they are profitable, because they literally run out of cash. Perhaps it is the timing of payments in or out, or bad debts, for instance. But anyone who has ever run a business will understand that issue – to some extent, it doesn’t matter how much profit your accountant tells you  the firm made last year. the big question is - have you got the cash for staff salaries or for the supplier, threatening to withhold supply because you’re late paying again?

That is what working capital means, and that is why managing working capital is high on any CFO’s (or indeed CEO’s) list of priorities.

Working capital has a number of elements – it is formally calculated as the difference between what we might call the positives (the current assets) and the negatives (current debts / liabilities). Long-term assets or liabilities are not included. So no property assets(on the positive side); or long-term debt (on the negative). Here are the key individual components.

Current Assets

  • Cash – actual money (or equivalent, like certificates of deposit) in the bank, the back pocket or the desk drawer!
  • Inventory – stocks that can be resold, both raw materials / components and finished goods
  • Creditors / accounts receivable – people, usually customers, who owe the organisation money
  • Other short-term assets – may be shares, bonds or other investment vehicles, or even loans to directors, but to count towards current assets / working capital they must be able to be realised quickly – so not a head office building or heavy factory equipment.

Current Liabilities

  • Debtors – people to whom the organisation owes money, including suppliers but also potentially the tax authorities, building landlords etc.
  • Payroll / tax liabilities – money owed to staff or to the tax authorities (typically corporate tax or VAT).
  • Bank overdraft – just like our personal overdrafts, money in effect borrowed from the bank as a short-term loan.
  • Other short-term liabilities – the inverse of the other short term assets. This could be loans or bonds,  or perhaps borrowings from directors in a smaller firm. To be seen as short term they usually require repayment in the next 12 months.

It doesn’t need a genius to see where procurement can help the working capital position. Managing the outflow of cash to suppliers is a key element of working capital management. That doesn’t necessarily mean it is a good thing to extend payment terms indiscriminately, which raises issues around supplier management, reputation and even ethics. But it is fair to say that whilst standards vary in different countries, not many CFOs would want to see their organisations paying much faster than industry averages – unless there was a real benefit (see comment below on supply chain finance).

Procurement can also have a role in forecasting working capital through understanding usage,  expenditure and payment profiles  better. Procurement can perform a useful service for the organisation by knowing when major invoices are due, and perhaps developing  some flexibility with suppliers to manage payments at times. Often, firms don’t have a systemic working capital problem, but may have certain times of the year when they need to be careful.

There may be other more subtle ways in which procurement can contribute in larger firms – tax issues for instance, where goods are traded internationally. And there are many supply chain finance issues and opportunities these days . That’s too large a topic to cover here today,  but is another opportunity area for firms (particularly those with positive working capital positions) to help suppliers, whilst boosting their own profitability.

In general, procurement functions and professionals don’t talk enough about working capital management. I know I didn’t as a CPO. But it’s well worth understanding how you can contribute, as this is an issue of importance to anyone at the top levels.

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