As the old saying goes, “cash is king.” When people hear this phrase, the insinuation is that cash flow is vital to a healthy, thriving business. The fact of the matter is, if a company lacks cash flow, it will quickly make it difficult to perform various operations, ranging from everything to funding operations and making payments to upholding necessary capital requirements. On the other hand, when liquid funds are available, it offers a business a great deal of flexibility and a serious advantage. That’s why investors place so much emphasis on looking at working capital management.

Why does working capital matter?

When analyzing the financial health of a business, working capital can be a useful tool for investors who are seeking to find out more about the financial health of a business. The term “working capital” typically refers to the money necessary to meet short-term obligations and current operations. This would refer to cash in bank accounts and undeposited checks. Securities, such as U.S. treasury bills, also count as working capital.

Working capital reveals the difference between a company’s assets and liabilities.

Investors would want to review the company’s accounts, both accounts receivable and accounts payable, as well as current inventory levels. When a company has inventory or supplies that remain unused, cash is tied up and therefore is not able to contribute to the expansion of a business. Further, if a company has clients who delay on paying their invoices, this will limit their working capital. The same is true when companies pay suppliers quickly and before they have a chance to receive payments for the goods.

Looking for proper management of funds

Proper management of working capital is key. If a company is able to generate a cash surplus, then it can free up that money for various purposes including returns for investors.

It’s easy to think of good examples on both sides of the spectrum. For example, big retail companies sell goods and immediately receive payment. Yet, manufacturing companies must pay significant amounts of money up front and often receive payment months later. This is only to be expected with a manufacturing company and will not necessarily indicate its financial health.

Clearly, the use and management of funds can only be expected to vary wildly from one type of company to the next. For example, an insurance company receives payments without the need for creating and generating supplies. On the other hand, the outflow of money can be unpredictable.

What is DSO?

If you are investing in a company, you’ll want to look at supply chain management. Think about “days sales outstanding” (DSO). This provides insight into how many days it takes to receive payment after each sale.

Since DSO reveals the number of days a business holds debt on its books, it can give you tremendous insight into the cash flow of a business.

When calculating DSO, you can take the number of accounts receivable during a period of time and then divide it by the total value of credit sales during that time. Then multiply that number by the number of days in the time frame being measured.

If DSO rises, this can mean a company is encountering significant issues. The company is potentially taking too long to receive funds. In turn, the company may start to experience issues with funding operations. When you see a spike in DSO, this can mean a company is experiencing cash problems.

How to evaluate companies

When looking at working capital, it can also be useful to look at the process of transforming raw materials into a finished sellable product. Then you can look at the process and time frame between the production of these products to the sale and generation of income.

Looking at the ratio of inventory turnover can help you figure out how well a company’s working capital management is operating. It will show you how fast goods are moving. After all, when products don’t move, the company is not bringing in income on the invested capital. In some instances, of course, a ratio increase merely means that a company is adding inventory because it expects a rise in sales.

You can also take a look at how a company compares to competitors. Of course, if a company is needing to restock less than its competitors, it clearly means it is not generating as much income.

Again, it’s important to consider how different companies can be, depending on the industry. Sometimes the typical guidelines aren’t even applicable. For example, if you were looking at a software company, you’d want to keep in mind it is not selling physical inventory. Therefore, the expenses for inventory would be much less.

Yet, there are still beneficial ways that software companies can increase their working capital management.

However, oftentimes, CEOs think that the only way to boost cash flow is to borrow and raise equity. Or worse yet, if they are having money issues instead of reducing their DSO, they try to cut costs and restructure. That may work temporarily, but can cause problems in the long run.

Taking the right precautions

If you are investing in a company and you see cash is flying out the door, you should be on guard. To make the best decisions, be sure to carefully evaluate a company’s working capital. This will give you knowledge about how the company deals with cash. And it will also help you anticipate if the company is likely to have cash available to not only fund growth but also boost shareholder value.


Bob Wolter is Mergers & Acquisitions Advisor of Creative Business Services/CBS-Global.

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