In my work helping companies transform themselves to take better advantage of economic opportunities and to manage risks more efficiently, working capital risks are frequently overlooked even though they are at the front line of risks faced by companies of all sizes.
The cash conversion cycle, an important liquidity measure that usually forms the core of a company’s working capital, is of particular importance . The cash conversion cycle is a measure of how long it takes for a dollar that is spent on the development of a product or service (which is subsequently sold on to a client) to be converted back into cash in the form of revenues. Mismanaged it can destroy a company’s finances.
Let’s pause for a minute to define some terms. Working capital (WC) is calculated by subtracting a company’s current liabilities from its current assets. A company’s assets and liabilities are deemed current if they have a maturity of less than one year.
We need to understand three further terms when it comes to the cash conversion cycle (CCC). Accounts receivable (AR) refers to money that a company is owed by its customers, and sits on the asset side of the balance sheet. AR arise when payment is deferred. For example, if Etisalat provides a customer with a phone for AED 1,000 and allows the client to pay in 30 days, then that amount is added to Etisalat’s AR when it is sold, and removed when the client pays it off.
The period between when an AR is created and when it is paid is called days outstanding (DO). Similarly, accounts payable (AP) refers to money owed by the company for goods and services that it has received but not paid for yet (DO has a similar meaning in this context), and sit on the liability side of the balance sheet. Finally, there is inventory (INV), which refers to finished goods that are ready for sale but have not been sold yet. So, for example, all the phones that Etisalat holds in stores and warehouses are considered inventory. Inventory days outstanding simply means the average time that inventory is held. Inventory is an asset.
The cash conversion cycle in basic terms is equal to how long it takes to sell plus how long it takes the customer to pay minus how long it takes the company to pay, or CCC = INV DO + AR DO – AP DO in formula terms.
Why is this critical? Because it needs to be funded. If the cash conversion cycle stays stable over time, then the company should not in general face problems. But what if the conversion cycle widens out, i.e. It takes longer to convert cash? For example, what if business slows down? This would lead to inventory taking longer to sell, so INV DO would increase, which would need to be funded. An astute manager would then cut the total amount of inventory and so bring the conversion cycle back into balance.
The real trouble begins when clients take longer to pay and the AR DO widens out significantly. One of the nastiest traps in this case is for the company to fund the gap by borrowing from banks. This is dangerous, as the new debt does not go into operations or capex but rather to pay off creditors. It might make better sense to talk to the company’s creditors and increase the AP DO to balance the increase in the AR DO. Unfortunately, this merely moves the pain down the line. The result is a chain of companies who are tapped out in terms of cash and work solely to pay their creditors.
Perhaps companies facing such pressure should consider shutting down. Sadly, it’s usually not that simple. The problem lies in the balance sheet. Many non-current liabilities will suddenly become current liabilities and a company’s working capital balloons. A simple example for UAE companies is end of service benefits (EOSB), usually calculated as one month’s current pay per employee multiplied by the total years on the job.
The EOSB is a non-current liability and is usually quite large. To get a feel, the profit to equity holders of Etisalat for 2016 was AED 8.4 billion whilst their EOSB was AED 1.6 billion. The non-current portion of their loans stood at AED 18 billion, which would of course become due if Etisalat decided to wind down (which they aren’t). But you get an idea of the relative sizes of liquidity that would be needed. In the case of a company like Etisalat with large operations and a well-known brand, the best move may be to seek a strategic buyer to help it out. But for most SMEs that is simply not an option, meaning they are stuck.
Companies that were viable under previous business models formed in the midst of different economic realities need to transform themselves into companies that can not only survive but thrive in our changed economic environment in the UAE and the wider region. This requires fresh thinking and shareholders or boards with open minds. The longer we wait to make such changes, the larger the cost will be.
A version of this article was originally published in The National on December 21/12/2017.