Obviously, there is no simple answer to that question as it is dependent on several parameters such as cost of capital, potential capital release, cost of improving working capital and timeline. However, let’s take an example to make it a bit more concrete:
It’s important to understand that capital comes at a cost. Either it is interest rate from a bank, or it is expectation of yield from owners - financiers will demand some return on their investment.
Let’s say it is a manufacturing company, then the performance would be rather average. The company is making money and if there are no great seasonal fluctuations, liquidity is probably not an issue. But that is not to say there is no room for improvement. Currently, the company increases working capital with 200 MSEK for every billion it increases turnover. For every million invested in working capital, only half a million is generated in EBIT.
Furthermore, it’s important to understand that capital comes at a cost. Either it is interest rate from a bank, or it is an expectation of yield from owners - financiers will demand some return on their investment. Weighted average cost of capital (WACC) is often used to give an overall price tag of capital. Depending on how the company is financed, this could vary. But looking at a company that uses a mix of equity, bank loans, and short-term debt, 10% is usually a realistic figure. One should note that WACC will not be present in the P&L and a company can play around with different WACC depending on how important capital is considered. For instance, during a tight liquidity situation, you might want to increase WACC to send a message to the organization that capital is considered very expensive. However, this is a different topic.
So what would be a realistic target for working capital reduction? Based on data from 300 working capital projects, we on average manage to reduce working capital by 25% within 12 months. In this case, that would mean 250 MSEK in capital reduction one year after project start. Applying a WACC of 10% gives us a capital cost reduction of 25 MSEK / year.
What is the pay-off time then? Well, everything costing less than 25 MSEK would indicate a pay-off time of less than a year. Looking at historic project data on companies with similar turn-over and working capital levels, project cost is substantially less – around 15-25%, depending on complexity. This means that the pay-off time is measured in months, not years, and thus should be considered rather attractive as a means to increase company value.
Of course, this is a very simplified example and one might argue that project cost and WACC are not comparable as one will impact P&L, whereas the other will not. However, companies must find a way to compare cost with capital and if capital cost is too low, then the company is more likely to tie more capital and this might lead to difficulties in growing liquidity issues and reduced attractiveness among investors. Setting the capital cost too high, then you’ll risk end up overpaying for goods or selling at a discount which will negatively affect your EBIT. So, it has to be a balance in order to facilitate sound business decisions that generates a healthy capital structure.
Need a working capital expert?
Capacent has carried out over 300 working capital projects and have experience from most industries. So if your company is pursuing working capital reductions, do not hesitate to contact Erik Påhlson (firstname.lastname@example.org). We would be glad to make sure you get the most out of your initiative and are happy to tie our compensation to achieved results.
Erik Påhlson is Managing Director at Capacent_x. Erik has experience from driving working capital projects in a wide range of industries, such as manufacturing, trading companies, utilities, and retail.
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