How to strategically manage your working capital

🛠 THE CFO EFFECT PLAYBOOK (Part II)

The Current Ratio: Why all ratios aren't created equal

In the previous chapter, we discussed that a healthy current ratio typically hovers around 1.2.

However, one critical caveat is often overlooked: the current ratio is only as good as its components.

Consider this scenario:

- One company has a current ratio of 1.8, while another has a ratio of 1.3.

- On the surface, the company with the higher ratio might seem healthier.

- But appearances can be deceiving.

- The true story emerges when we examine the composition of the current assets that make up these ratios.

Current assets vary significantly in liquidity:

• Cash is the most liquid and valuable current asset.

• Receivables are moderately liquid and beneficial, but slower to convert to cash.

• Inventory ranks lowest in liquidity and poses the greatest risk. It’s also important to understand the mix between raw materials, work in progress (WIP), and finish goods. Sometimes finished goods are more valuable; other times raw materials hold better marketability.

This liquidity spectrum highlights why a high current ratio can be misleading if it's predominantly made up of inventory.

Going back to our previous example, the company with the current ratio of 1.8x could have way more illiquid current assets than the company with a current ratio at 1.3x

To solve this problem, we need to look at another ratio: The quick ratio.

Why you need the quick ratio (Acid Test)

To tackle the inventory issue, finance professionals use another essential measure: the quick ratio (acid test).

The quick ratio formula is straightforward:

Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities

By removing inventory from the calculation, we get a clearer view of true liquidity.

If your current ratio falls dramatically after excluding inventory (say from 1.8 down to 1 or below) you have a problem.

Your balance sheet is overloaded with inventory, creating a serious liquidity risk.

This scenario played out widely among direct-to-consumer (D2C) companies during COVID.

On paper, their ratios seemed perfect (often above 1.2), but a deeper look revealed inflated inventory levels, frequently obsolete or slow-moving.

When I was a banker, I witnessed this exact situation with a client who resisted inventory audits, fearing the discovery of obsolete stock and consequent financial losses.

The other extreme situation is not good either.

If a company has only cash and receivables, but its inventory is completely depleted, it could and will cause sales problems down the road.

Without inventory you can’t meet demand, and if you can’t meet demand your business is going to shift to your competitors.

Lesson: Be skeptical of surface-level metrics. Always dig deeper into the quality of assets behind the ratios.

Step 1: Days Sales Outstanding (DSO)

DSO indicates how quickly your customers pay their invoices.

In other words, it measures how many days it takes for you to turn receivables to cash.

Monitoring this trend is crucial.

If your DSO rises from 10 days to 30, or 60, it's an immediate signal to question your credit policies and sales procedures.

During the pandemic, DSO surged as customers delayed payments to preserve liquidity.

It also surged because salespeople were pushing sales through generous payment terms.

Address rising DSO proactively:

• Ensure strict adherence to your credit policies.

• Engage your collection and sales teams to enforce timely payments.

• Pay sales commissions only on the money collected, not deal closed.

Most finance teams know to watch their DSO (Days Sales Outstanding).

But there’s a trap most miss: your channel mix can completely distort the picture.

Let’s say your credit terms are 30 days. But your DSO is 45, 60, or even 90 days. Alarm bells should go off.

That's probably a collection issue. But hold on.

If your business sells both B2B and DTC (e-commerce), lumping all sales together skews the numbers.

E-commerce payments are instant. B2B payments are not.

So, if your e-commerce sales increase, your DSO might look artificially healthy.

But your B2B collections could be deteriorating, and you'd never know.

Here’s the fix: isolate your B2B channel and calculate DSO only on those sales.

That’s the only way to get a true read on your receivables’ performance.

Because until you separate the channels, your DSO is just a blended average that tells you nothing.

Step 2: Days Inventory Outstanding (DIO)

Most CFOs monitor DIO as part of their working capital dashboards.

But few truly use it as a forward-looking indicator of margin pressure and strategic misalignment.

Let’s break this down.

The signal behind the metric

Say your target inventory is 90 days. But now it’s creeping to 120, maybe even 180.

Here’s what that actually means:

• You’re not moving product. Either demand has dropped, or your product mix is off.

• You’re financing excess stock. That’s trapped cash. And the longer it sits, the more it eats into your margin (via warehousing, obsolescence risk, or markdowns).

This isn’t just inefficient. It’s dangerous.

I once reviewed a portfolio company where DIO ballooned to 150 days because the product team over-ordered a soon-to-be-phased-out SKU.

Sales refused to push it.

Ops had nowhere to send it.

Finance was stuck paying to store it, with no way to recover the cash.

It ended in a $500K write-down and 200 bps of margin erosion.

Interpreting DIO in context

Now pair DIO with deferred revenue. This is where the strategic clarity kicks in.

Case 1: High Deferred Revenue + Low Inventory

This combo screams supply chain failure.

You’re taking orders faster than you can fulfill them.

You may be booking unearned revenue, but you’re also building frustration.

Cancellations, refunds, and lost customer trust will follow.

What to check:

• Lead times: Are they stretching?

• Forecast accuracy: Are sales outpacing ops capacity?

Case 2: High deferred revenue + High inventory

This one is more subtle, but more costly.

You’re sitting on product and cash from customers.

That means sales and ops are misaligned. Either:

• Marketing is promising what ops can’t deliver.

• Or production/purchases is producing/buying what the market no longer wants.

This is where channel strategy and inventory planning need a serious reconciliation.

Otherwise, you’ll burn trust, margins, and eventually liquidity.

Inventory mismanagement doesn’t hit your P&L immediately. But here’s what’s coming:

• Warehousing costs: higher storage fees.

• Cash burn: financing excess stock with short-term credit, increasing interest expense.

• Discount-driven decay: fire sales damage brand equity and train customers to wait for discounts.

• Write-offs: slow movers eventually become dead stock, hitting COGS.

How to Get Ahead of the Curve

1. Segment your DIO by product category and channel. One number tells you nothing.

2. Overlay DIO trends with sales velocity. Are you building inventory ahead of demand, or chasing it?

3. Run inventory-to-deferred-revenue ratios. If that number’s out of sync, dig deeper. It’s your early warning system.

4. Ask your ops lead this question: “Which 10% of inventory is most likely to be written down in the next 90 days?” Then pressure test it.

Step 3: Deferred Revenue (Unearned Revenue)

Most finance teams treat deferred revenue as a simple accounting liability: cash collected, product not yet delivered.

But smart CFOs know it’s more than that.

Deferred revenue is one of the most real-time indicators of operational health and future margin exposure.

Especially in e-commerce, where the timing between order and fulfillment can vary wildly.

What deferred revenue really tells you

Let’s break it into two truths:

1. It’s cash in the bank. You’ve already collected the money.

2. It’s a delivery obligation. That revenue doesn’t belong to you, yet.

So, while it looks great on your balance sheet, deferred revenue comes with serious operational strings attached.

The operational questions that matter

When deferred revenue builds up, you need to interrogate it, and fast.

• Are you holding the right inventory to fulfill these orders quickly?
  If not, you’re sitting on cash and customer expectations you can’t meet. That’s not profit. That’s a refund waiting to happen.

• Are supply chain issues slowing delivery?
  Extended DIO + rising deferred revenue might mean operational drag. That mismatch will eventually hurt your NPS score, your cash flow, and your brand.

• Are marketing expenses outpacing delivery?
  If your CAC is booked but revenue isn’t recognized yet, your P&L may look misleadingly weak or strong.

One e-com client I worked with had their CAC out of control… on paper.

But their deferred revenue was surging due to shipping delays.

They were under-forecasting profitability while customers were waiting for their orders. This mismatch led them to reduce marketing efforts that were bringing results.

Strategic misreads to avoid

A sharp drop in deferred revenue can look like a good thing.

• Revenue recognition goes up.

• Margins appear to expand.

• Cash-to-P&L conversion accelerates.

But don’t be fooled. This could mean:

• You’ve fulfilled a wave of orders, but have no new demand coming in.

• You’re burning through your order backlog without replenishing it.

This is the inverse of overstocking.

Instead of excess product, you’re running short on future demand.

How to Use Deferred Revenue as a Strategic Lever

1. Map it by product category. If 70% of your deferred revenue is tied to one SKU, ask: is that product in stock? On water? Or stuck in customs? Or even being produced?

2. Overlay it with marketing spend. Deferred revenue ≠ real revenue. Match CAC against fulfilled orders but check it with sales orders too.

3. Run a delivery risk heatmap. Flag high deferred revenue + low inventory SKUs. That’s your refund exposure zone.

Deferred revenue is not just a balance sheet item. It’s a forward-looking stress test.

Ignore it, and you’ll get blindsided.

Track it proactively and it becomes your early warning system for fulfillment risk, cash drag, and margin misreporting.

Step 4: Days Payable Outstanding (DPO)

Most CFOs look at DPO as a simple working capital metric: the longer you take to pay suppliers, the more cash you hold.

But there's nuance (and power) hidden beneath the surface.

DPO is not just about stretching payables.

It’s about managing trust, timing, and leverage across your supply chain.

Let’s break this down.

The Danger Zones

• Paying too early (e.g., 15 days on 30-day terms):
  You’re funding your suppliers with your own liquidity, while your own cash might be needed elsewhere (inventory, ad spend, or debt service). Unless you’re earning a meaningful early payment discount, this is just a silent drain on your cash runway.

• Paying too late (e.g., 60 days on 30-day terms):
  You’re burning supplier goodwill. The penalties may not be financial at first, but they’ll show up eventually: slower order fulfillment, stricter payment terms, or getting dropped as a customer during allocation shortages.

DPO abuse doesn’t show up in your balance sheet; it shows up in lost trust and reduced flexibility.

How to use DPO strategically

This is where experienced finance pros differentiate themselves.

You don’t just pay late. You pay intelligently.

Here’s how:

1. Build a supplier tier map.

   • Tier A: Critical vendors with high dependence on your volumes.

   • Tier B: Strategic, but replaceable vendors.

   • Tier C: Transactional or commoditized vendors.

Negotiate DPO targets differently for each tier.

Use your leverage where you have it and preserve trust where you need it most.

2. Use early payment discounts as a working capital asset.

Let’s say a supplier offers 2%/10 net 30.

If you have surplus cash, that’s a 36% annualized return for paying 20 days early. Better than most investments.

But only if your working capital structure can support it.

3. Create DPO guardrails by liquidity condition.

   • Strong liquidity? Optimize for discounts.

   • Tight liquidity? Extend DPO within agreed terms but communicate openly.

   • Crisis mode? Prioritize suppliers by criticality and renegotiate proactively.

4. Review DPO performance monthly, not annually.

Most companies only review supplier payment terms once a year, usually during budget season.

That’s a mistake.

Supplier dynamics, liquidity position, and business priorities shift constantly.

Track your average DPO trend and segment by supplier type.

Proactively flag opportunities or risks.

CFO Insight: Managing DPO isn’t about delaying payments. It’s about orchestrating cash flow, trust, and strategic leverage across your supply chain.

Do this well, and your suppliers will support your growth (even in lean times).

A Holistic Strategic Approach

Improving one ratio without considering the broader context can mislead.

An improving quick ratio might seem positive initially but could mask underlying issues like slowing demand or poor receivables collections.

Always approach these metrics comprehensively, analyzing the root causes and their interrelations strategically.

Summary and Strategic Reminders

• Look Beyond Current Ratio: Use the quick ratio to get a clear liquidity picture, free from inventory distortions.

• Monitor DSO Trends: Identify potential credit and collection issues promptly to safeguard liquidity.

• Manage DIO Strategically: Align inventory levels with actual demand to minimize hidden costs.

• Deferred Revenue Insight: Use deferred revenue as an early indicator of supply chain and fulfillment issues.

• Optimize DPO: Balance supplier payments strategically to protect cash flow without sacrificing supplier relationships.

Next Week’s Episode:

🔜 Case Study: What CFOs can learn from Restoration Hardware's luxury meltdown

The best CFOs don’t just report numbers: they read them, decode them, and proactively shield the business from financial disaster.

From FY22 to FY24, Restoration Hardware (RH) had it all: premium branding, industry-leading margins, and seemingly unstoppable momentum.

But then, everything went sideways.

So what exactly went wrong?

Next Sunday, I'll walk you through the RH financial unraveling to reveal the critical lessons every CFO must learn:

✅ Why capital allocation is your best ally

✅ How vanity projects can cripple financial stability

✅ Why balance sheet analysis is your window into the future of margin

✅ How strategic overreach without financial discipline can unravel even the strongest luxury brands

Because a single quarter of promising growth can dangerously mask deeper financial vulnerabilities.

If you're committed to ensuring your company's growth strategy remains financially disciplined and resilient—avoiding the costly missteps that took RH from leader to laggard—you can’t afford to miss this episode.

Disclaimer:
This content is for informational and educational purposes only and should not be construed as financial, legal, or professional advice. Always consult with a qualified advisor before making any business or financial decisions. The author and publisher disclaim any liability for actions taken based on this content.

Talk soon,