Working capital, also known as net operating capital, presents a picture of the operational liquidity of a business. But there is more to it than meets the eye.
The success of a business actually depends to a significant extent on how it deals with its working capital needs.
The difference between working capital and working capital needs
Within the financial analysis, working capital is just one of the indicators that present a picture of the operational liquidity of a business. It not only affects general management, but also the access to bank credit or the valuation of the business, for example. This is calculated as follows:
Equity capital and other resources in the long term - fixed assets
This allows you to see whether sufficient long-term funds are available to finance the production chain. Where there is a positive result that is indeed the case, whereas with a negative result it is actually the production chain that must safeguard the long-term financing.
It is therefore useful to calculate the working capital needs as well:
Current assets (excluding cash) - current liabilities (excluding financial liabilities)
The result shows the amount the business needs in order to finance its production chain, and may be both positive and negative:
- where working capital needs are positive, the commercial debts no longer cover the short-term assets (excluding the financial). In that case, a business can rely on its working capital. If this is insufficient, it will need additional financing for its operational cycle in the short term;
- where working capital needs are negative, a business can meet its short-term liabilities without any problem. Nevertheless, it is advisable to reduce working capital needs (further).
In short, working capital presents a picture of the operational liquidity of a business, whereas working capital needs represent the amount the business needs in order to finance its production chain.
In other words, it boils down to limiting working capital needs as far as possible, thus increasing liquidity. This is crucial, especially in times of economic or financial difficulty. After all, customers tend to pay later then, while your stocks are increasing and your suppliers are imposing stricter payment terms. As a result, more and more working capital gets 'frozen' in your operating cycle, precisely when circumstances make it more difficult to attract additional financing.
Optimising working capital is not only a question of long-term considerations. In the short term, too, the business can release cash that is not being used optimally, or is being used unnecessarily, more specifically in the purchasing, production and sales processes within the operating cycle.
The working capital and the working capital needs must, above all, be geared effectively to each other. The working capital needs must be structurally less than the working capital itself, preferably with an extra buffer. However, there is no mathematical truth regarding the amount of working capital and working capital needs. Sector, activity and business model can affect this, for example.
The cash conversion cycle reviewed
A good barometer of how great the demands of your operating cycle are on your working capital is the 'cash conversion cycle'. This is expressed in number of days and shows how long money is tied up in your business's purchasing, production and sales processes.
The calculation of the cash conversion cycle is based on:
- the number of days' customer credit (DSO – Days Sales Outstanding):
the average number of days that your business must wait for payment after a product or service is delivered.
- the number of days' stock rotation (DIO – Days Inventory Outstanding):
the average number of days that your business needs to convert stock into a sale.
- the number of days' supplier credit (DPO – Days Payable Outstanding):
the average number of days that your business needs to pay suppliers.
The shorter the cycle, the less capital is held in the business process, which allows you to meet your short-term liabilities and expand your activities.
Simplified presentation of the cash conversion cycle
4 rules of thumb to get your working capital working for you
Although entrepreneurs are familiar with the term working capital, all too often they fail to use its full potential. This is a mistake, because targeted management of their working capital needs can bring huge advantages, both financially and at an organisational level.
How a business approaches that in practice is obviously closely linked to its own specific situation and the sector in which it operates. Below is a number of general rules of thumb:
1. Analyse your business processes
A logical first step is a thorough analysis of your working capital needs, based on the cash conversion cycle. The idea is to clearly identify the following business processes:
- management of your customer payments
How long does it take before your invoices are paid? Why do some invoices remain outstanding? How aware are you of your customers' financial situations?
- management of your supplier payments
What payment terms are you getting? Do you get a discount if you pay quickly? Do you use advance financing?
- management of your production and stock
How far can you deplete stocks without jeopardising production? Can you shorten the production time in order to reduce the amount of work in progress? Do you work according to the Just-in-Time system or have you decided to go for Economic Order Quantity?
You will then find out where there is room for improvement and how you can shorten the cash conversion cycle. The idea is to reduce your working capital needs and, by doing so – by dealing more frugally with the available capital – increase the return from your general management.
2. Collect faster and better
Adequate monitoring of your accounts receivable is crucial. Relatively small, obvious interventions can sometimes produce a surprisingly big benefit. Here are some tips:
- Monitor the quality of your invoices. A good invoice will quote a correct amount, a payment due date and will be received promptly by your customers.
- Invoice smaller amounts on a regular basis and avoid summary invoices where possible.
- Actively follow up outstanding invoices and find out why they remain unpaid. Is it down to the customer's financial situation or are there other factors to consider? Disagreement over the amount charged or problems with the delivery or sale often cause delays or result in non-payment. By aligning your accounts and services more efficiently, you end up with a win-win situation: satisfied customers and fewer disputed invoices.
- Solutions such as factoring or direct debit are a particularly profitable route to take. These lead to swifter collection without putting pressure on your customers or tightening up your payment terms, which is always delicate in a commercial relationship.
A clear picture
Without an overview of your accounts at home and abroad and of your incoming and outgoing payments, management of your working capital is virtually impossible. So, you need clear, immediately available information and reporting. Different solutions for electronic banking, reporting arrangements with your financial partners and efficient operation of your accounts and bookkeeping will help you considerably here.
Another profitable route is the centralisation of your cash and cash equivalents, which will dramatically simplify both the management and monitoring of these. Often this also offers numerous options in terms of fiscal optimisation.
3. Make optimum use of your supplier credit
Making sure your invoices are paid systematically in order to build up your number of days' supplier credit seems a painless and effective intervention, but it is the least you should do. After all, there is a good chance that the supplier will pass on the charge for the longer payment term in the price you pay for subsequent deliveries. There are a number of better alternatives:
- See whether or not it would benefit you to pay more quickly – in many cases early payment carries an attractive discount.
- Choose solutions that let you pay later without the other party being affected. For example, by relying on lines of credit or working via reverse factoring, whereby the supplier receives an advance on your payments from the bank.
- Negotiate with your supplier for an extension to your payment terms.
Ensure you have adequate protection
Being able to get hold of your funds quickly is just one aspect of optimum management of your working capital. Another is the assurance that your customers will actually pay, while at the same time your business must project confidence to (potential) trade partners. To that end, you can call on the various forms of documentary credit. By engaging credit insurers, you are also hedging the risk of the other party defaulting on payment.
Another important factor, certainly as far as international transactions are concerned, is the exchange rate risk. Although you may know when you are going to get paid, the exact amount depends on the exchange rate at the time of payment. Because the difference between a good and a less favourable exchange rate can have a big effect on your margin, you are better off hedging yourself against possible exchange rate fluctuations.
4. Get maximum performance from your stocks
The financial impact of your inventory control should not be underestimated. Just think about invoices that are outstanding after a faulty or late delivery, or holding on to too much stock of slow-selling products. The advantage of the latter is that you can always deliver promptly, but it does freeze a major part of your working capital. A few guidelines:
- Check your stocks and prices regularly, preferably using a package like Enterprise Resource Planning (ERP) or a web-based application with direct link to your opposite parties.
- A warehouse management system will allow you to retain a good overview of your quick and slow-selling products, so you can adjust your stock accordingly.
- Keep your finger on the pulse of the market so that you can correctly assess demand, and thus avoid stock surpluses or deficits.
- You can also choose a radically different course and outsource your stock management to a logistics service provider.
- Use stock financing to keep cash and cash equivalents available for other purposes.
- Hedge yourself against price fluctuations on the raw materials markets, to protect your margin.
An exercise in balance
Optimising your working capital needs is therefore a continual exercise in balance between your accounts receivable, accounts payable and inventory control. It is a stiff challenge, but essential if you are to increase your financial might and steal the march on your competitors. Get your working capital to perform!
Biolectric is achieving growth with its anaerobic digesters
A young Belgian company that installs biogas facilities on farms is growing fast. Here’s how BNP Paribas Fortis is helping its development.
Biolectric is the epitome of the sustainable do-economy: it manufactures and sells anaerobic digesters, which are installed on farms so as to produce ‘green’ energy based on the biogas released from the farm’s own manure. The green heat and power generated from cow dung make the farm an energy-positive business. No less important is the fact that this approach reduces emissions of the powerful greenhouse gas methane by up to 70%. The average Biolectric reduces greenhouse gas emission by an equivalent of 2.000 kilometers driven in an modern car.
The company, which started up in 2011 in the East Flanders municipality of Temse as a typical scale-up, nowadays sells anaerobic digesters to farmers all over Europe.
Biolectric is a fast-growing company. In 2019, in order enable further growth, the bank provided the firm with a series of credit facilities, mostly in the form of a ‘sustainable impact loan’.
Tom De Winter is Biolectric’s contact at BNP Paribas Fortis. He tells us: “The bank has been working with Biolectric since the very beginning, but the relationship has become much closer since 2017. In order to obtain a better grasp of their technology, I’ve visited the firm several times with expert from our Sustainable Business Competence Centre. It’s very important to be able to understand and evaluate the firm’s technical proposition. When Biolectric founder Philippe Jans and industrial investment company Ackermans & van Haaren (AvH) came to talk to us last year about the imminent onboarding of the company by AvH, and the subsequent creation of a new low-threshold business segment, namely the construction of a facility with its own anaerobic digesters so as to be able to sell electricity to farmers in Belgium, the Netherlands and France, we knew straight away that we ought to go along with them on the project.”
“We weren’t the only bank in the running, but the client had clearly chosen us. The coordinated approach of BNP Paribas Fortis and our clear policy of backing sustainable solutions played a big part in that decision,” explains Tom De Winter.
As a pioneer, Biolectric has independently developed compact anaerobic digesters, known as ‘pocket digesters’, specifically designed to turn cattle dung into electricity and heat. Today there are over 200 of the company’s installations operating all over the world. This technology provides Biolectric farmers with a very nice economical as well as ecological return on their investment.
In 2019 Ackermans & van Haaren, which is also a BNP Paribas Fortis client, acquired a 60% stake in the company from Taste Invest, with founder Philippe Jans retaining the remaining 40%. AvH brings its professional management experience to Biolectric, thus strongly boosting the firm’s growth potential.
#StrongerTogether Coronavirus government bonds deliver extra €8 billion
The coronavirus crisis prompted the Belgian Treasury to issue additional debt securities. In just a few days, BNP Paribas Fortis and four other Primary Dealers launched a new government bond on the institutional investment market.
Treasury certificates and government bonds (known as OLOs) are an important source of financing for the Belgian State. They offer investors the possibility to lend money to the country in exchange for periodic interest. At the end of December last year, the Treasury assumed it would have to issue debt securities worth €30 billion in 2020. That would happen via an increase in the number of existing bonds, and through two new OLO transactions.
The corona crisis increased the country’s financial needs significantly. So, at the end of March, the Federal Debt Agency decided to issue additional tenders for the OLOs in circulation. It also immediately halted the repurchase of certain bonds, and raised the issuance target for Treasury certificates.
An additional measure was the issue of a third new government bond: OLO91. “This is a medium-term loan,” says Jean Deboutte, director of the Treasury. “The maturation date is 22 October 2027. With a zero-percent coupon, this bond is neutral for our annual budget.
“We wanted to bring OLO91 to market as quickly as possible. That has happened in a period of just a few days. It is also the largest ever OLO issue: €8 billion. We have attracted investors from 31 different countries, and around one-fifth of the volume comes from non-European buyers. That confirms the worldwide popularity of Belgian government bonds.”
The fast launch of OLO91 is in part thanks to BNP Paribas Fortis. “As a Primary Dealer, we take care of the placement and promotion of the bond among institutional investors,” says Director Debt Capital Markets Stefaan Van Langendonck. “We also reinforce activity and generate liquidity of OLOs and treasury certificates on the secondary market.”
Belgium has 12 primary dealers. They drew up a contract with the Treasury based on the Code of Duties. “BNP Paribas Fortis can rightly consider itself one of the most important intermediaries for Belgian bonds,” says Mr Van Langendonck. “Each year, we are invariably among the top three most active Primary Dealers in the country. Often we are number one.”