US economic figures show importance of working capital management

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Andrew Mosely, Deputy Managing Director, writes on design and business analysis

Yesterday’s GDP figures from the United States should have come as a surprise to no-one. The preceding quarter’s growth, of nearly four percent, always looked remarkably fizzy for an economy where the recent trend has been one of steady, but unremarkable progress. However, the figures were particularly interesting for drawing specific attention to the sharp drop in inventory held by US firms.

The real implication of inventory levels at any one point in time is debatable – swollen inventory can be a sign of confidence or of misplaced optimism, depending on how long it lasts. However, this vivid example should serve to remind us of the importance of working capital management to overall business performance. It may be the drumbeat of a successful organisation but, because it does not have the transformative potential of revenue or margin, it does not always receive its due attention from finance leaders.

The ambiguities around the implications of working capital as an indicator are reflected in strategies for its management. Too zealous a drive for efficiency, or too cautious an approach to supply chain redundancy, can both lead to trouble. Like much in business, control of working capital is a balancing act, but achieving the right balance should be a science, not an art.

The foundation of that science is understanding how working capital creates value for the business. In a modern organisation, that means making sense of a tangle of costs and assets. Inevitably, the best way to do this is via a visual representation, so the factors driving each business outcome can be mapped in an intuitive manner.

With the support of technology, that map can be transformed into a dynamic mathematical model of the business. If we use software to build a data hierarchy reflecting the inputs of each driver of value, and incorporate the calculations determining how each driver results in an outcome, we can then explore possible future scenarios to test the outcomes of potential changes in the business.

This is not the conventional way of looking at inventory management. Even in large companies, decisions on stock ordering are often taken according to a simple forecast, which may or may not be based on an objective assessment of demand. Similarly, optimum accounts receivable and accounts payable levels are often decided according to a rule-of-thumb, with little thought of how changes could affect business performance.

The driver-based approach, as outlined above, is a much more objective means of understanding the value of working capital. Given the right technology platform, this method is within the grasp of any finance department, and can afford significant gains in efficiency, quickly, and at relatively little cost.

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