Treasury Today Country Profiles in association with Citi

Working capital and the financial supply chain

In last month’s Cash Management article we looked at financial supply chain management and the reasons why this approach has become a major topic in the treasury world. This month we look in more detail at the relationship between working capital management and the financial supply chain.

What is working capital?

Working capital means different things to different people. From an accounting point of view it is defined as current assets minus current liabilities on the company’s balance sheet. Current assets include cash, short-term marketable securities and accounts receivable as well as inventory. Current liabilities include accounts payable, wages payable, short-term loans, short-term debt and current repayments on long-term debt. This definition can be useful as a measure of the company’s liquidity.

A further definition of working capital excludes the company’s debt from the definition, defining working capital as current assets minus trade creditors. This calculation provides a useful measure of the funds that the company has to find to provide the necessary liquidity in the business.

Whichever definition is used, working capital management is ultimately concerned with the cash flows moving around the company. Specifically, it is concerned with the three main components of the working capital cycle – accounts payable, inventory and accounts receivable.

Working capital management

Working capital management is the art of keeping working capital at the optimum level needed in order to meet the company’s obligations without tying up excessive levels of cash. Even a profitable company will be at risk of financial disaster if it does not have enough cash available to meet its payments, or enough inventory to fulfil its orders. Working capital is also frequently used as a measurement of a company’s solvency and may, therefore, impact on the company’s ability to obtain financing – another reason why a healthy working capital position is important.

So what is the optimum level of working capital? Different companies will take different approaches to this question. An aggressive approach would be to keep working capital levels pared down as low as possible, maximising profitability while also incurring the greatest risk of difficulty if unforeseen circumstances mean that a higher level of cash becomes necessary. On the opposite end of the scale, a conservative working capital policy would ensure that a greater proportion of the company’s assets are held as short-term assets, reducing the risk of not being able to meet short-term liabilities – but also reducing the company’s profitability.

In order to manage working capital effectively, it is necessary to look at the individual components of working capital in order to see where efficiencies can be gained.

Accounts payable

One important working capital measurement is Days Payables Outstanding (DPO), which is based on the number of days taken by a company to pay its creditors in a given period. From a working capital perspective, ideally DPO should be as high as possible as this means that the cash is available to the company for longer. The formula for calculating DPO is:

DPO = Accounts Payable Cost of sales × Number of days in period

By increasing the payment terms offered to suppliers, companies can hold onto their cash for longer. However, this strategy may have other consequences – such as sacrificing early payment discounts or adversely affecting the company’s relationship with its existing and potential future suppliers.


Another important measurement is Days Inventory Outstanding (DIO), also known as Days Sales of Inventory (DSI). While DPO and DSO relate purely to cash flows, DIO is a measurement of the number of days taken to convert inventory into sales. DSI is calculated using this formula:

DIO = Average inventory Cost of sales × 365

The lower the DIO figure, the faster inventory is being converted. One strategy which many companies have adopted in order to drive down DIO is the just-in-time production model. Using this model, companies order raw materials on a need-to-use basis, rather than holding significant amounts of stock. This has the advantage of reducing warehouse costs and preventing components from becoming obsolete – and it also ensures that the minimum amount of the company’s resources are tied up in goods.

However, this strategy does come with a certain degree of risk which needs to be carefully assessed. The shorter the inventory turnover period, the greater the impact of any disruptions in the supply chain will be.

Accounts receivable

The measurement commonly used to measure a company’s working capital performance in terms of accounts receivable is Days Sales Outstanding (DSO). This is defined as the average number of days taken by a company to collect payment from a completed sale. DSO is calculated using the following formula:

DSO = Accounts receivable Total credit sales × Number of days in period

The lower the DSO, the faster payment is collected and the sooner cash can be used for other purposes. In order to reduce DSO, companies can adopt strategies such as offering customers incentives such as early payment discounts or taking a more proactive approach towards chasing in late payments. Alternatively they may choose to finance their receivables, ensuring that the majority of a due payment is received on a specified date.

The Cash Conversion Cycle

Another metric used in working capital management is the Cash Conversion Cycle (CCC). This measurement is also sometimes known as the ‘cash-to-cash working capital cycle’ or the ‘cash cycle’. It is calculated using the three metrics already discussed:


Visually this can be represented as follows:

The CCC is a measure of the number of days taken to convert resources into cash – ie the number of days between purchasing resources which will be used to produce goods and the receipt of payment for the sale of the finished product. The target is a shorter CCC, as this means that capital is locked up internally for a shorter period.

Diagram 1: The cash coversion cycle

The CCC can be shortened by reducing DSO, reducing DIO or increasing DPO. In some cases it is possible for a company to have a negative CCC, meaning that payments are received from customers before suppliers are paid for the raw materials. This has been made possible by the ability of corporates in certain industries to negotiate credit terms with their suppliers while selling goods to customers for cash (or in some cases, cash in advance).

Negative cash conversion cycle

Large retailers, most notably supermarket chains, are well positioned when it comes to keeping the cash conversion cycle as short as possible. Not only are they in a position of power when it comes to negotiating credit terms with their suppliers – they also receive payment from their customers at the moment at which they part with their goods, keeping DSO to a minimum. This means that many supermarkets (and other retailers) have no working capital requirements. They generate surplus cash simply by trading.

Dell is the oft quoted example of a company that has achieved a negative cash conversion cycle. This is because under Dell’s direct business model, customers pay for goods in advance, while its suppliers are not paid for the raw components until after the goods have been sold. Meanwhile, the slick just-intime production model adopted by Dell means that inventory is held by Dell only briefly, as machines are built to order. In Dell’s preliminary financial statements for the third quarter of fiscal year 2007, released in November 2006, Dell reported a CCC of -40 days – including a DIO figure of just five days.

While this measurement can be useful as a means of tracking whether a company’s working capital efficiency is improving or deteriorating over a certain period, caution should be exercised when using this calculation. CCCs vary significantly from industry to industry, meaning that benchmarking against companies from other industries is not a meaningful exercise. An additional difficulty is that the individual components of the CCC calculation are not, strictly speaking, directly comparable as DIO and DSO are based on the value of the finished goods whereas DPO is calculated according to the cost of the raw materials.

Working capital and the financial supply chain

Achieving the optimum level of working capital is widely agreed to be a key concern of financial supply chain management. However, some voices within the treasury community are beginning to dispute the importance of the measurements that have historically been used to measure working capital, arguing that while a strict focus on DSO, DPO and DIO can do wonders for the health of the balance sheet, it can also mean that the bigger picture is overlooked.

Supplier relationships

Working capital is a major concern not only for the MNC but also for its suppliers and vendors – in other words, the other parties involved in the supply chain. One of the features of supply chain management is considering all of the parties in the chain. Doing so from a working capital perspective immediately raises the issue that their contrasting objectives inevitably position them as adversaries. For example, the goal of the supplier is to receive payment as early as possible. The goal of the company purchasing from the supplier is to delay payment for as long as possible. The winner in this scenario is usually the stronger party. For example, large multinational retailers have increasingly been imposing longer and longer payment terms on their suppliers.

From a working capital perspective, therefore, the purchasing company has achieved what it wanted to achieve. Payment has been delayed, leaving the funds available for as long as possible. However, when looking at this scenario from the point of view of financial supply chain theory, the impact on the other parties in the chain also needs to be considered. What will be the consequences of extending payment terms on the supplier? Will it be forced to raise prices to compensate?

Some retailers have pre-empted this possibility by demanding price reductions at the same time as extending payment terms, but this approach ignores some of the other possible consequences of piling this amount of extra pressure on suppliers. Will delivery be delayed as the supplier struggles to finance its own output? Will the supplier even be driven out of business? Considerations such as these mean that companies with an interest in financial supply chain management are increasingly taking a partnership approach towards the other parties in the chain, rather than seeing them as adversaries.

In response to this predicament, certain types of technique have been developed which enable the supplier to receive early payment while also benefiting the purchasing company.

  • Early payment discounts.

    One example of this is the early payment discount, which provides the buyer with a discount (for example, 2%) if payment is received within 10 days instead of the usual payment period. This provides the supplier with much needed cash while giving the buyer an incentive for paying early.

  • Supplier finance.

    An alternative approach developed by the banks is supplier finance, also known as reverse factoring. This is a receivables discounting arrangement whereby the bank provides the supplier with a percentage of the invoice value up front while the buyer pays the bank in full later on at the agreed payment date. Unlike other receivables financing techniques, supplier finance is offered to the supplier on the basis of its customer’s creditworthiness and therefore is offered at a significantly lower rate of financing than the supplier would be able to negotiate on its own.

We will discuss these techniques in more detail in our upcoming handbook ‘Managing the Financial Supply Chain to Add Value’, which will be published later in 2007.


While financial supply chain management is certainly concerned with working capital management, it is only part of the story. Supplier relationships is one area where the discrepancy between the goals of working capital management and financial supply chain management is particularly apparent, and it is on this point that many banks have focused when developing financial supply chain solutions.