Family businesses use working capital more often.
Family enterprises have significantly more working capital compared to non-family enterprises, according to research by Nicolas Heidelk who examined the working capital of 682 German family enterprises. This is mainly due to holding higher inventories and due to higher accounts receivable balances. But high working capital is not necessarily beneficial.
The discussion of working capital – money tied up for a short period of time in inventories, work in progress or accounts receivable, for example – has many faces. The term suggests “possession,” but that is incorrect. Working capital, simply put, is the difference between current assets and current liabilities. When working capital is positive, short-term assets are greater than short-term liabilities (outstanding accounts payable and accrued liabilities). When current assets are greater than current liabilities, it is referred to as positive working capital. The amount of working capital obviously depends on the sector in which the company operates: a service provider will have much less inventory than a wholesaler.
A positive working capital is not necessarily advantageous
A positive working capital sounds beneficial, but it does not have to be. In fact, from a financial perspective, positive capital is seen as a liability that must be financed. The underlying causes of a high positive working capital can also be negative. Working capital may be high because there are many (overdue) debtors, or because the (legal) persons who have to pay are not solvent. Inventory may also be too high because of the wrong purchasing policy or because of old or unsellable inventory, or it may be because creditors are paid (too) quickly.
Cash conversion cycle
To indicate how efficient a company is in converting investments into cash flows (cash), we use the term cash conversion cycle. If working capital is relatively high, the cash conversion cycle is long. The shorter the cash conversion, the higher the return on invested capital. Companies with a short cash conversion cycle tend to manage their working capital strictly.
Downside of too strict working capital management
A company can also go overboard in its working capital management. Little working capital may mean too little inventory. Deliveries cannot then be made when there is demand from customers. This occurs in business-to-business (B2B) but certainly also in sales to consumers. We experienced this in the Netherlands with the advent of private equity in retail. Due to the enormous pressure on financing, this meant limiting the size of working capital. As a result, companies looked strictly at inventory and managed it through “just in time” deliveries. As a result, companies often failed to deliver on time and customers grabbed hold. Limited inventory means “selling no” which can have long-term effects on sales but also customer relationships.
Why family businesses use working capital
Heidelk’s research shows that family businesses use more working capital. To my knowledge, no comparable studies have been done in the Netherlands, but this research does confirm our experience in practice with Dutch family businesses. The underlying reasons that family businesses use more working capital must be sought in the character and focus of family businesses: they are long-term oriented. Family businesses therefore cherish relationships with suppliers and customers. They keep more inventory and work less with a “just-in-time system” to avoid “selling no” and maintain warm relationships with their customers. In addition, family businesses tend to be reliable in paying the bills so there is a low accounts payable ratio and they are careful about collecting money from debtors. The combination of these makes for greater working capital and thus a longer cash conversion cycle.
Working capital as a strength of the family business
A high working capital requirement leads to higher financing needs. The advantage of a time like this is that interest rates are low. But money tied up in working capital cannot be used to make other investments, such as to accelerate growth. In some cases, too much working capital is also a signal that a company has too much or the wrong inventory, or that customers are not paying because there is malaise in the market or they are not satisfied. External parties such as banks will thus raise critical questions when working capital is relatively high.
But high working capital can also be precisely a choice for a family business that underscores the strength of the family business and its relationship with its customers and suppliers. If the capital is there to invest in accounts receivable and inventory and to pay creditors on time, it may yield more in the long run than the most efficient working capital management.
Would you like a no-obligation discussion with us about your working capital? Then call Clifton Finance:
Maarten Vijverberg +31 6 55853074 or Gonneke van der Lee +31 6 52466518
Bronnen
Working Capital Management in Family-owned Businesses
Does Family Ownership Influence the Length of the Cash Conversion Cycle? Nicholas Heidelk – 1008 – M.Sc. Global Management & Governance 2015 – Master ́s Thesis – HSBA