The Best at Managing Working Capital

What do Boeing, Ford, Gillette, Coca-Cola, Herman Miller, Timberland, Southwest Airlines, and Burlington Northern Santa Fe have in common? Each of these companies leads its industry in CFO magazine's annual survey of working capital management, which covers 1,000 firms with sales greater than $500 million. Each company is rated on the number of days to its cash conversion cycle and on its cash conversion efficiency (CCE), defined as cash flow from operations divided by sales.

According to this survey, the median number of days in the cash conversion cycle is about 57. Burlington Northern Santa Fe (BNSF) has an outstanding cash conversion cycle of — 51 days, versus an industry average of 12! BNSF achieved this by reengineering its accounts receivable process, starting with the number of days it takes to submit a bill to customers. In 1997 it had about 50,000 bills on hand each day that had not yet been priced and renderd to customers. By working on its information systems, BNSF was able to automate much of the process, and it reduced unprocessed bills to about 15,000. BNSF then turned its attention to the number of days it takes a customer to pay. They found that their large customers would receive a batch of bills, but not pay any of them if the customer disputed any single bill in the batch. Working closely with marketing and sales, BNSF was able to greatly reduce the number of disputed bills. The net result of these efforts was a decrease in the days sales outstanding from 50 to 16. When coupled with very little inventory and its own ability to delay payments to its suppliers, BNSF's cash conversion cycle came in at —51 days. This increased its free cash flow to such an extent that BNSF was able to implement a large stock repurchase program.

Source: Various issues of CFO. For an update, see and search for "working capital annual survey."

However, the picture changes when uncertainty is introduced. Here the firm requires some minimum amount of cash and inventories based on expected payments, expected sales, expected order lead times, and so on, plus additional holdings, or safety stocks, which enable it to deal with departures from the expected values. Similarly, accounts receivable levels are determined by credit terms, and the tougher the credit terms, the lower the receivables for any given level of sales. With a restricted policy, the firm would hold minimal safety stocks of cash and inventories, and it would have a tight credit policy even though this meant running the risk of losing sales. A restricted, lean-and-mean working capital policy generally provides the highest expected return on this investment, but it entails the greatest risk, while the reverse is true under a relaxed policy. The moderate policy falls in between the two extremes in terms of expected risk and return.

Changing technology can lead to dramatic changes in the optimal working capital policy. For example, if new technology makes it possible for a manufacturer to speed up the production of a given product from 10 days to five days, then its work-in-progress inventory can be cut in half. Similarly, retailers such as Wal-Mart or Home Depot have installed systems under which bar codes on all merchandise are read at the cash register. The information on the sale is electronically transmitted to a computer that maintains a record of the inventory of each item, and the computer automatically transmits orders to suppliers' computers when stocks fall to prescribed levels. With such a system, inventories will be held at optimal levels; orders will reflect exactly what styles, colors, and sizes consumers are buying; and the firm's free cash flows will be maximized.

Recall that NOWC consists of cash, inventory, and accounts receivable, less accruals and accounts payable. Firms face a fundamental trade-off: Working capital is necessary to conduct business, and the greater the working capital, the smaller the danger of running short, hence the lower the firm's operating risk. However, holding working capital is costly — it reduces a firm's return on invested capital (ROIC), free cash flow, and value. The following sections discuss the individual components of NOWC.

Identify and explain three alternative working capital policies.

What are the principal components of net operating working capital?

What are the reasons for not wanting to hold too little working capital? For not wanting to hold too much?

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