Working Capital is a function of value and time
A company’s operational working capital is money tied up in the business, from buying and paying for raw materials, to selling and receiving payment for its final product.
This capital must be financed by the company. If too much money is tied up for too long, the company will have less available cash to do other good things with, like financing growth, investing in newer equipment or paying back loans.
The length in time each working capital component is held is determined by a set of trigger actions or activities.
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So, how much Working Capital should a company carry?
A company should carry enough working capital to ensure they can deliver products or services to its customers as agreed, on-time and in-full, with as little friction and waste as possible
This level is not a random choice or personal whim, but rather a calculated level based on factors such as: supplier and customer commercial terms, restocking lead-times, demand profile and variability, safety requirements and process control
This balance of not-too-much and not-too-little is what we call a company's SETPOINT
Why is too much or too little working capital bad for you?
Let us look at it from the perspective of 3 different groups of friends going on a hike, each having chosen a guide to plan and lead the adventure.
The first guide, Harry, had run out of food on his last hike and really wanted to make sure this group would not go hungry. He therefore packed double food rations, leaving everyone's backpack filled to the brim and heavy to lift.
Also, in order to fit all the food, he had to leave all rain coats at home. The weather forecast looked promising, so the decision made sense to Harry at that point.
The second guide, John, sees life as a competition and took a different approach. He wanted his team to move fast, and did not pack any food at all. "We can buy food on the way as we get hungry" he reasoned.
This decision made a lot of sense to John, as he knew the hiking cabins along his planned route carried some basic snacks and foods for sale.
The third and last guide, Lisa, decided to adjust her approach to her group's stamina and speed. She packed just enough food for the trip, based on her estimation of how long she thought it would take the group to finish the hike.
She reasoned she could always use the hiking lodges to replenish any additional food requirements, should any unforeseen events occur along the way...
...and away they went!
John and his group took off like a rocket. Lisa and her group followed suit, however at a more moderate pace... Harry's group came last, slowly staggering forward, burdened by their heavy back packs.
On the second day of the hike they experienced an unforeseen and heavy rainfall - to the extent that some of the hiking paths were cut off. Including some of the hiking cabins.
A few days later, on schedule, Lisa's group arrived at its destination - fairly dry and in good spirit, despite the rain.
Harry's group came in second, 2 days later. Cold and wet, albeit well fed, they stumbled over the finishing line.
John's group did not arrive at all. He had been forced to abort the hike when realizing his group would not find any food along its planned route...
The moral of the story is of course that Lisa was right - by understanding her group's SETPOINT, she was able to plan an optimal trip - even in the face of unforeseen events.
The challenge is, of course, that in order to know what your company's SETPOINT level is, you first need to understand its underlying supply chain conditions and inherent constraints.
However, it is fully worth it! Properly applied, a company’s SETPOINT denotes a working capital steady state, from which all internal processes operate in harmony with suppliers and customers alike.
This equilibrium help provide perfect value for the end-customer, with as little friction and waste as possible – positively impacting working capital, top-line and cost.
This is the basis for Lean Working Capital.