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Calculum Inc
The Basics of Working Capital Management
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Calculum Inc
Our media pack is available for download and contains the Calculum logos and company information. If you’d like to receive our press releases, organise an interview, and collaborate on a content piece, please contact us.
Welcome to Calculum’s content series on Working Capital Management: The Forgotten Cash Flow Lever. As part of this series, we hope to provide an overview and foundational understanding of the importance of working capital management and supplier payment terms for your company.
In the intricate world of finance, the term "Free Cash Flow" often emerges as a focal point for businesses focused on growth and shareholder returns. In part 2 of this content series, we dive into the concept of Free Cash Flow, its relationship to working capital, and how companies strategically harness these principles to drive success.
While revenue and income are critical, transforming these bookkeeping entries into tangible cash is the ultimate game-changer. For companies, it's easy to get lost in the pursuit of income and revenue, but the true significance lies in turning that revenue into Free Cash Flow.
Why? Because this is the cash that provides returns to shareholders and debt investors. The more Free Cash Flow a business can generate, the more it can allocate that cash to investing in growth, shareholder returns, and paying down debt.
Delving into the mechanics of Free Cash Flow, we encounter two pivotal aspects:
Firstly, Free Cash Flow is net income plus non-cash expenses like depreciation minus changes in working capital. If working capital grows, Free Cash Flow goes down.
Secondly, capital expenditures are deducted, that is the cash cost associated with purchasing long-term assets that generate income. These expenditures cover assets like factories, equipment, and computers.
Boosting Free Cash Flow can be accomplished using two primary levers. The first is improving net income through revenue growth or trimming expenses, including the cost of goods sold (COGS). COGS refers to “direct” expenses — for instance, the steel used in manufacturing steel boxes.
The second Free Cash Flow lever is increasing asset efficiency, that is, reducing the assets required to generate each dollar of revenue. This enables a company to maintain or grow income without the need to make commensurate asset investments. It can be accomplished by either reducing working capital or capital expenditures. For example, if a company could maintain its net income but cut working capital by $100 Million, Free Cash Flow would increase by $100 Million.
Companies differ in their ability to manipulate these levers. High-growth businesses may find it easier to increase revenue and, consequently, net income. Meanwhile, companies in mature markets or larger enterprises may shift their focus to asset efficiency—generating the same or modestly greater revenue with reduced investments in assets such as working capital.
Several characteristics come to the forefront when identifying prime prospects for working capital optimization. Companies in low revenue growth environments often benefit from focusing on asset efficiency because it is difficult for them to grow revenue by double-digit percentages each year.
Also, those with high working capital/sales or capital expenditure/sales ratios will benefit greatly from improving working capital efficiency, as will companies in industries where a high percentage of their spend is with suppliers (rather than, say, with staffing).
Real-world examples illuminate these principles. Ametek, a $6 Billion electronic components manufacturer, aggressively manages working capital to increase free cash flow and bolster shareholder returns.
In the financial ecosystem, the journey from income to Free Cash Flow is a critical one and the nexus of Free Cash Flow and working capital management holds the key to unlocking financial success. By adeptly managing accounts receivable, inventory, and accounts payable, businesses can secure a smoother transition from income to Free Cash Flow, thereby propelling their growth and stability in an ever-evolving landscape.
