With December 2022 financial results completed, it is time to re-evaluate the 2023 forecast and consider working capital needs. Lines of credit often renew after the calendar year end; therefore, this is the opportunity for the borrower and its lender to evaluate the size and structure of the line of credit used to support working capital needs.
Undertaking this type of working capital and operating cycle analysis is especially important today. Companies have dealt with large commodity price swings and with rising overall input costs. With this backdrop, working capital planning becomes more critical. For example, a company that uses corn as an input has seen costs ranging from $3.08 per bushel on August 3, 2020 to $8.14 per bushel on April 25, 2022. A company that uses flour has seen wheat prices ranging from $4.38 per bushel in April of 2019 to $10.40 per bushel in May of 2022. During a three year time period businesses have endured input cost whipsaws coupled with overall inflationary pressures raising input costs for people and products. Using wheat as an example, if a company had an inventory of 100,000 bushels, the investment in inventory would have ranged from $438,000 to $1,040,000. That means that for just this one inventory item, this company, at a 60% advance rate, would have needed approximately $360,000 of additional capacity under its line of credit to handle this one input. The 60% advance rate on inventory would mean the inventory component on the borrowing base certificate increases from approximately $250,000 to over $600,000. And, the company would need to find a way – through accounts payable or cash – to fund an additional $240,000 for inventory, which is 40% of a $600,000 increase in inventory.
Let’s walk through a working capital analysis that will help plan for working capital needs in 2023.
The first step in this evaluation is to prepare an operating cycle analysis. Use the annual periods from 2019 through 2022, and the last 13 monthly periods. Calculate the operating cycle comparing accounts receivable (AR), inventory and accounts payable (AP) to sales. This will tell you the number of days sales the cash of the company and availability under the line of credit will need to support from a working capital perspective.
In the table below you will see how this type of analysis will look for the year over year periods. The same format should be used for the 13 monthly periods.
In this example, the operating cycle, pre-pandemic, was 15 days. That means accounts payable was able to provide significant support for accounts receivable and inventory, requiring cash or a line of credit to support 15 days of sales. In 2020, with the pandemic shutdowns occurring in March, receivables stretched, inventory was slightly reduced, and payables were also reduced. In 2021 the supply chain issues hit, causing inventory to reduce and vendor payables were paid faster to ensure product would be received. In 2022 receivables came back to 2020 turnover rates, but inventory turnover slowed significantly as the supply chain bottlenecks opened up. To provide cash in 2022, payables were stretched.
This example shows a real-world example of the impact on operating cycle caused by the performance excuses we are all hearing – shutdowns, supply chain, labor issues, inflation, commodity price changes.
Now the next step is to dive into the details of each component of the operating cycle.
For accounts receivable consider these questions:
How does the number of days sales in AR compare to the terms offered to customers. For example, does the turnover ratio tell you collections are occurring in 45 days, but terms are 30? Can you work to improve collection speed?
Are there large customers that impact the calculation? Do the large customers have different terms?
When do contracts with customers renew? What is the price and volume expectation and renewal?
For inventory ask these questions:
How has the days sales in inventory changed over time? Our clients have been experiencing increasing inventory levels in 2022 with slower turnover and more risk of incorrect stock for current customer demands. Take a hard look at inventory for these issues.
Evaluate turnover by SKU.
Consider the amount of freight costs in inventory.
Review the relationship between raw materials, work in process and finished goods.
For accounts payable ask these questions:
How has the use of accounts payable as a funding source changed over the period reviewed? How many days sales are the vendors supporting?
Are there large vendors that are impacting cash flow – some with faster terms or some with slower terms? Are prepayments for certain items required to ensure supply?
For all these working capital components, you will need to consider price volume variance analysis in your review. For example, if the price of your product has increased 30%, you would expect the same volume to require increased availability of cash, accounts payable, or lines of credit. When you consider your operating cycle, also consider changes in prices.
The third part of the analysis of adequacy of the line of credit will require looking at line of credit structure. Consider these factors:
Has the relationship between accounts receivable and inventory changed?
Are concentration limits in accounts receivable causing availability stress?
Is the relationship between raw materials, work in process and finished goods changing?
Are inventory component collars causing availability stress?
Evaluating price and volume changes from 2020 to 2022, does the size of the line still support the needs of the business?
When was the last inventory appraisal?
When was the last field exam?
Preparing this working capital analysis will allow a business to discuss line of credit needs with its lender. A business needs to evaluate its working capital position and be prepared to discuss cash flow needs with its lender. This evaluation of operating cycle and working capital should be added to the 2023 forecast and should become a part of the cash planning process. Preparing this type of analysis and additional forecast will put a company in a better position to manage working capital moving into the new year.
Tracking performance to plan is next. If the business does not already have KPIs related to working capital, this is the right time to implement KPIs targeting the 2023 forecast. Tracking should include:
Cash balances – book and bank.
Accounts receivables levels.
Aging.
Inventory by raw materials, work in process and finished goods.
Aging or turnover.
Accounts payable levels.
Aging.
In closing, 2023 is going to be a challenging year for working capital management. Preparing this analysis helps a business be confident they will be able to manage their cash flow. If you would like to discuss this approach, please contact us here.