Free Money: Yes, It Exists - Right Here on Your Balance Sheet
Unlocking Cash by Making Working Capital Work Harder
Managing working capital efficiently is a business imperative. For small to medium-size businesses, properly managing working capital can be a lifeline; for large, globally distributed businesses, it is the most effective business tool to benchmark the health of business units.
While the need to manage working capital is universally recognized, few businesses can claim to have mastered the art and science of unlocking its full potential. The management of working capital often is limited to reacting to traditional metrics such as days sales outstanding ("DSO") and inventory cycle times. That is analogous to driving a car forward while looking in the rearview mirror. Business leaders lose sight of the future trajectory and if any are short-lived and if initiatives are considered a seasonal phenomenon of spring cleaning at the operator level. This results in precious capital staying locked up for prolonged periods.
Where the Problems Lie
The root causes of poor working capital management are found buried in the operational processes and not the financial statements. Broken bridges across order to cash, forecast to deliver and procure to pay processes resulting in lack of transparency in cash flow operations, volatility in cash cycles, unplanned increases in transaction frequencies and nonexistent executive ownership for working capital performance are at the core of inefficient and ineffective working capital management.
We commonly see the following weaknesses across all industries in working capital management:
- Lack of process perspective
- Disconnected financial supply chain
- Average-based performance metrics
- Disengaged operating units
- Clashing incentive systems
These factors and behaviors can do serious damage to a company’s health.
Lack of Process Perspective
A lack of process perspective inhibits the proper prioritization of working capital improvements. Precious resources are misdirected, and enrichment projects never achieve their goals.
For example, driven by decline in drilling activity due to a precipitous fall in oil prices, a large oil and gas industry services business, found underutilized inventory for its existing contracts and declared a blanket ban on any new purchasing. Since the inventory was locked in for stipulated contracts, constraining the purchases of new contracts forced managers to wait, bypassing the inventory management process. This became a precedent and inventory as a percentage of sales exploded, tying up further capital and resources. Thus, the unintended consequence of a blanket ban on new purchases, while resulting in short-term improvement, culminated in a working capital disaster.
As with many businesses, this company viewed the stoppage of all procurement as the sole responsibility of the sourcing manager and failed to consider the effect on customer orders and execution.
As a permanent fix to this siloed approach, we recommended an analytics-driven, collaborative process across multiple internal stakeholders aimed at the company communicating with its key customers, explaining the need to release underutilized inventory for one contract to feed other contracts as a potential win-win situation.
A Disconnected Financial Supply Chain
Businesses today have a better (if not nearly perfect) understanding of their physical inventories than ever before. Most companies have made large- scale capital investments in supply chain management information technology projects that (if done right) give leaders the real-time or near real-time information needed to manage inventory and improve the physical supply chains. However, many of the benefits of an efficient supply chain can be lost when not integrated with the financial supply chain.
For instance, an iconic brand in seafood processing, with a well-managed global supply chain, was burdened with excessive working capital that was locked in for long periods. This situation was driven by a 16- to 20- week cold chain supply cycle in which seafood was caught in remote locations, refrigerated, processed and then shipped to the United States, where it was warehoused. This, in effect, held the company’s working capital hostage.
There was little to be improved in the physical flow. However, by contracting with a logistics service provider and transferring the ownership of the seafood to that company as soon as a shipment arrived at the warehouse (enabling the provider to more quickly supply its own customers at lower cost), the processing business was able to reclassify the warehoused seafood as accounts receivable. This enhanced the company’s ability to get cash from its credit line, allowing it to use that additional liquidity to take advantage of spot-buying opportunities.
Disconnects between physical and financial supply chains happen because business leaders largely are unaware of the benefits of an integrated approach and the remarkably positive impact such a system can have on working capital. The conversation among business functions too often is limited to optimizing the individual components of procurement, inventory and accounts receivable. Here, the seafood processing company, by transforming inventory to accounts receivable, integrated its physical supply chain with its financial one and freed up previously inaccessible cash to gain greater working capital efficiency.
Average-Based Performance Metrics
Our conversations with business leaders about working capital management reveal that an overwhelming majority rely on average-based metrics. Whether it is the DSO, days payable outstanding ("DPO") or days working capital ("DWC"), organizations typically report these as a single number. This can hide extreme variability in performance, and outliers can distort the truth. Operating with average- based metrics, an organization can fall victim to hidden problems or miss opportunities for improvement. Also, the chance to cultivate customers with a lower DSOs — and thereby decrease a company’s own DWC — may be overlooked.
For instance, a large manufacturer of aluminum extruded sections boasted industry-leading DSO performance. However, hidden in this averaged metric was a huge variability in performance. Some of the company’s large customers had a much higher DSO than average, locking up precious working capital at a time when every dollar counted. Several smaller customers had a lower DSOs. Averaged, the company's DSO metric looked great; in detail, not so good. In a period of tight money, the business chose to serve its large customers first. It neglected its smaller but actually better-performing customers and gradually lost them. This cycle continued until the business, fooled by its own metrics, filed for bankruptcy.
Disengaged Operating Units
In many organizations, working capital measures are reported only centrally. Regional and operating business units do not have adequate information about their own working capital positions and, therefore, cannot manage them properly. Worse, even in the corporations where the business units have visibility to the working capital, there is no mechanism to charge them for hoarding excessive working capital.
In one instance, the chief financial officer of a major consumer pharmaceutical company with multiple operations and brands had no working capital data at the local operating level. He largely ignored the working capital metric while paying attention to revenues and growth. Ultimately, the business lost its operational advantage and was forced to shutter several key plants, including the flagship operation that was synonymous with the company’s origin.
It was too late for the business to reopen that plant, but with the business in disarray, the management team decided to create integrated dashboards from various sites and began reporting working capital positions to all business units and charging them for locking in excessive working capital. This forced a behavioral change for the business units. An old adage of "what gets measured gets managed" took root, resulting in healthy competition among divisions and putting the business on a path of sustainable improvement.
Clashing Incentive Systems
Organizations tend to confine working capital management responsibilities within functions. When that’s the case, even incentive systems — especially when they’re at odds with one another — can impair working capital management.
For example, a sales department’s incentive systems generally promote behavior that produces higher sales. However, these sales frequently are secured by a combination of proliferating product lines to increase volume; relentless discounting; and easy, extended payment terms, all of which negatively impact working capital.
Meanwhile, the research and development function, incentivized for introducing novelty features and functionality, may create products with a cornucopia of functions and parts, resulting in complex, unwieldy and expensive sourcing chains that also can waste working capital. Some procurement functions may have their own performance drivers related to cost savings. And operational bonuses driven by production volume may encourage business unit leaders to focus on larger batch sizes while starving smaller ones, disappointing smaller but profitable and fast-paying customers.
A financial services corporation, for example, launched several innovative products. Its success depended on infomercials targeting new customers. The company’s media buyers, charged with getting the lowest cost in each media market, used the leverage they earned with multiple buys to cut those costs but compromised on airtime slots. That turned out to be a fatal mistake. The infomercials’ timing did not match the viewership of the target audience: The products flopped, and the business soon changed hands at distress-level valuation.
To improve working capital efficiency, incentive systems must be informed by a risk analysis within each business function that contributes to components of working capital. This holistic approach ensures that incentive plans are not misaligned, as was the case with the financial services company and its media buyers. Incentive plans should promote behaviors the entire company wants, not simply actions that move an individual function’s needle.
Making Working Capital Work Harder
Opportunities for better working capital management are there for almost every company, but the clues aren’t in the quarterly reports. Business leaders who dig deep can transform working capital management from a finance-only function to a strategic priority across all business units.
The best way to unlock invested capital and increase cash velocity is with an approach that integrates the three key processes of the cash-conversion cycle: order to cash, forecast to deliver and procure to pay. We also find it best, typically, to tackle improvements in a three-step process:
Step 1: Conduct a Comprehensive Assessment
Facilitate cross-functional evaluations that promote an understanding of the interplay of working capital activities within and across functions. In addition, this assessment phase can uncover opportunities to reduce product and after-sales service complexity — the low- or no-value-added activities that can cause excessive working capital investment. And this evaluation can identify areas to link parallel processes such as the supply chain and its associated financial transactions.
Focus on the root causes of radical performance. For instance, profiling DSOs and taking a hard look at extremes can highlight possibilities with specific customers and the sales staff that supports that audience. An in-depth review also can yield lessons from customers with shorter DSOs. Similar circumstances may exist on the DPO spectrum where vendors with a low DPO are penalizing other vendors.
Step 2: Scope and Plan Integrated Working Capital Management Improvement Projects
Prioritize opportunities across the value chain on a capital-time-investment matrix to deliver the highest returns for time and resources invested.
Step 3: Implement Projects and Monitor for Sustainable Results
Manage projects as a portfolio: planning, implementing, monitoring and tracking working capital improvements against a base line. Clearly assign responsibility and accountability for each, and determine how the outcome will be measured. Reporting should be pushed to lower levels throughout the organization. That’s where the action is — and that’s where improvements can be made.
Finally, supplement process enhancements with incentive programs and reporting analytics that will induce behavioral changes and cultural shifts.
Almost every company has areas where its working capital position can be improved, creating favorable conditions for investment and reducing borrowing costs. But it takes attention to detail to identify where gaps exist. And it demands that people work together across business units and functions. Orchestrating all that requires senior- level ownership. Very often, the chief financial officer is the person in the best position to sponsor the initiative; he or she, in turn needs business operations to own the working capital measures and help move them in the right direction. An integrated approach to managing working capital benefits everyone in the company and the business itself.