Working capital is a highly effective barometer of a company's operational and financial efficiency and effectiveness. The better its condition, the
Working capital is a highly effective barometer of a company’s operational and financial efficiency and effectiveness. The better its condition, the better placed the company is to focus on developing its core business.
The early, primitive attempts at maximizing cash management can be traced back to the late 1970s. Unbelievably, there are still some companies who haven’t yet understood that putting cash trapped in the balance sheet to better use can give them a competitive edge over their rivals.
A most recent report shows a further reduction of working capital in companies in the US and Europe compared with the previous year, of between 3 per cent and 5 per cent. This demonstrates the continuing increase in the importance of working capital management to help companies achieve their strategic objectives.
How to do It
There is more to working capital management than simply telling a company to collect its debtors as quickly as possible, to delay paying its suppliers as long as possible, and to keep stock levels as low as possible. A properly conceived and executed improvement program will certainly focus on optimizing each of these components, but will deliver additional benefits that extend far beyond the merely operational. It will demonstrate the need for ambitious corporates to integrate working capital management into their strategic and tactical thinking, rather than view it as an optional bolt-on extra.
There are a number of dos and don’ts to help guide corporate thinking. Firstly, do think of working capital management as a strategic objective that can enable your corporation’s goals. We cannot over-emphasize this opening point. The same factors that drive a company’s working capital also drive its operating costs and customer service performance. Therefore, by addressing the drivers of working capital a company will also experience significant improvement in operating costs and customer service.
For example, a company’s working capital is deteriorating due to an increase in past due accounts receivable (AR). A review of the overdue AR illustrates a high level of customer disputes. The disputes are taking on average 30 days to resolve and consuming significant amounts of sales, order entry, and cash collectors’ time. By tackling the root cause of the disputes, in this case poor adherence to pricing policies, the company can eliminate the disputes, thereby improving customer service.
This will free up the time of staff in sales, order entry and cash collections, enabling them to be more effective at their designated roles. This in turn increases productivity, reduces operating costs, and potentially increases sales. Working capital will improve, as customers will have fewer reasons to hold payment. This example illustrates how working capital is one of the best indicators of underlying inefficiency within an organization.
Consider Another Perspective
Don’t think of things only from your own company’s perspective. If you can help your own customers plan their inventory requirements more efficiently, for instance, you can match your production to their consumption, efficiently and cost-effectively, and do the same with your own suppliers. The potential implications for inventory levels are huge. By aligning ordering production and distribution processes, you increase inherent efficiency and achieve direct cost savings almost instantly, as a by-product. And then you discuss the best way to bill or to pay.
Do educate your organization to consider the trade-offs between different working capital assets when negotiating with customers and suppliers. Depending on the usage pattern of a raw material, there may be more to gain from negotiating consignment stock with a supplier versus pushing for extended terms. This could apply particularly in cases of long lead-time items, or those that require high minimum order quantities.
Agree Formal Terms
Do agree formal terms with suppliers and customers and document those terms carefully. Keep them up to date, and communicate those payment terms to employees throughout your business, particularly those involved in the customer to cash and purchase to pay processes, including your sales organization.
Don’t allow prolific new product introduction without a clear product range management strategy. Poor product range management creates inefficiency in the supply chain, as companies are required to support old products with inventory and manufacturing capability. This increases operating costs and exposes the company to an obsolete inventory that may have to be disposed of.
Collect your Cash
Don’t forget to collect your cash. Many businesses fail to implement effective ongoing collection procedures to prevent excess overdue funds or build-up of old debtors. Ask customers if invoices have been received and are clear to pay. If not, identify the problems that are preventing timely payment.
Confirm and reconfirm the credit terms agreed upon with the customer. Often, credit terms get lost in the translation of general payment terms and what’s on the payables ledger in front of the payables clerk. Do devote the requisite amount of time and attention to the critical issue of dispute management.
Don’t set top-down targets uniformly across the business. For instance, too many companies impose a 10 per cent reduction in working capital for each division. This fails to take into account the potential opportunity within a division and can result in setting an impossible target that acts to de-motivate. Instead, balance top-down with bottom-up intelligence when setting targets.
Targets Drive Behaviour
Do set targets that drive the desired behaviour. Many companies will incentivise collections staff to minimize the aged AR over 60 days. Does this mean that customers who pay one to 60 days late are good payers? No, aged AR over 60 days will result in increased costs and time it takes to collect the debt. By incentivising staff to lower the amount over 60 days, you keep your costs down. Do educate staff, customers and suppliers that cash and cash management are important, and are an integral part of a successful business relationship.
Look Within Yourself
Don’t assume that all the answers are to be found externally. Before approaching existing customers and suppliers to discuss cash management goals, fully understand your own process gaps so you can credibly discuss poor payment processes.
Do treat suppliers as you would like your customers to treat you. Far greater cash flow benefits can be realized by strategically leveraging the relationship you have with suppliers and customers. In addition, a supplier is more likely to support you in an emergency if you have treated them fairly.
Don’t however, treat everyone the same. Use segmentation tactics to split your customer supplier into similar groups. This may be based on a basket of criteria including profitability, sales, AR size, past due debt, average order size and frequency. Define strategies for each segment based around the criteria and your strategic goals.
Do celebrate success in hitting targets. Emphasise the actions that helped you get there.
To summarise briefly, following the dos and don’ts will enable you to optimize cash and to highlight inefficiencies in your processes that must be remedied to better serve customers. It will enable you to build stronger partnerships with your suppliers across the total working capital value chain. This translates ultimately into improvement in bottom-line results, often a good deal quicker than you might expect, and helps clarify the senior management focus on strategic imperatives.
REL Consultancy Group www.relconsult.com are global specialists in generating cash improvements, cost reductions and service enhancements by optimizing working capital. They are the only international corporate financial consulting firm that focuses exclusively on increasing operational efficiency from working capital and operations. They work with people to transform your organization, your customer’s and your suppliers in more than 60 countries around the world.