In our extensive interactions with clients, a recurrent trend has been the widespread adoption of overdraft facilities as an integral component of companies’ funding strategies. While overdrafts play a pivotal role in enhancing critical working capital for businesses, caution is warranted, especially for CFOs, to ensure that overdrafts are maintained at an optimal level. This vigilance is crucial as some companies find themselves in precarious situations due to excessive borrowing beyond their actual needs, while others witness a substantial erosion of EBITDA due to escalating interest costs.
Addressing the urgent need to reduce overdrafts entails a meticulous analysis of a company’s historical data, unveiling fundamental flaws not readily visible eye amidst the demanding schedule of a CFO.
Given the direct correlation between overdrafts and working capital, this blog delves into the top analytical techniques that leading CFOs employ to curtail working capital (WC) levels, consequently leading to a reduction in overdraft limits.
Analysis of the WC-Turnover Ratio
Definition and Significance
The WC turnover ratio, representing the sales-to-average working capital ratio, serves as a pivotal metric. A higher ratio signifies a faster rotation of capital, reducing the money tied up in working capital and subsequently lowering overdrafts.
Determining the Ideal WC-Turnover Ratio
Recognizing that there is no universal ideal ratio applicable to all companies, it becomes imperative to calculate the ideal WC turnover ratio specific to each company.
(as a comparative note you may choose to have a look at the industry’s best practices and create your own benchmarking for an easier start) This involves a meticulous evaluation of the working capital cycle, considering credit terms, inventory policies, and vendor payment terms. The calculation, though seemingly intricate, is streamlined through Business Intelligence tools like BiCXO, providing real-time data. The ideal WC turnover ratio is derived by dividing 365 by the WC cycle.
Desired vs. Actual Working Capital Levels
The next critical step involves a comparative analysis of desired and actual working capital levels. This comparison unveils the potential to reduce working capital and, consequently, overdraft limits. The magnitude of the gap serves as an indicator of the opportunities for companies to optimize working capital.
80-20 Analysis
Recognizing that a holistic understanding of the overall gap might be insufficient, an 80-20 analysis becomes imperative. This involves scrutinizing which products or business segments contribute significantly to the gap. Conducting a working capital gap analysis at the product and business segment levels provides insights into areas where there is a substantial variance between ideal and actual working capital. Business intelligence tools, equipped with algorithms, facilitate the seamless execution of this analysis.
Components of Working Capital: Receivables and Inventory
Focus on Identified Products/Business Segments
With clarity on products and business segments requiring attention, the focus shifts to the components of working capital, namely receivables and inventory. While detailed strategies for reducing receivables and inventory are covered in separate blogs (referenced via links for collections and inventory), this blog emphasizes the necessity of addressing these components for the identified products and business segments.
Continuous Monitoring and Benchmarking
Setting Benchmark KPIs
Recognizing that this optimization is an ongoing process, CFOs are advised to establish benchmark Key Performance Indicators (KPIs) for WC-turnover ratio, Days Sales Outstanding (DSO), and Inventory holding period at both the overall and product/business segment levels.
Continuous Monitoring and Deep-Diving
To ensure efficacy, these KPIs demand continuous monitoring. CFOs are encouraged to delve deeply into areas exhibiting significant deviations. Business Intelligence tools, equipped with alert mechanisms, prove invaluable in notifying CFOs of deviations from set KPIs and past trends.
CFOs can effectively bridge the gap between ideal and current working capital levels by conducting a root cause analysis and implementing robust monitoring mechanisms. This proactive approach ensures that the action plan remains aligned with strategic objectives. As the financial landscape evolves, CFOs must remain adaptable, fostering a culture of continuous improvement and vigilance in working capital management. Through a meticulous and data-driven approach, CFOs can steer their companies toward financial resilience and sustainability.