11 Ways Companies May Improve Their Working Capital Position
With interest rates continuing to rise, oil and commodity costs mounting and ever-increasing pressures from Wall Street to increase shareholder value, it’s surprising that some companies are not taking more measured steps to drive effective cash management and increase free cash flow.
Working capital is a highly effective barometer of a company’s operational and financial efficiency and effectiveness. The better its condition, the better positioned a company is to focus on developing its core business. By addressing the drivers of working capital, in fact, a company is sure to reap significant operating cost and customer service improvement.
According to an analysis of financial results from the 2,000 largest companies in the U.S. and Europe performed in 2005 by Hackett-REL, U.S. and European companies have reduced working capital by 12 percent and 17 percent, respectively, over the past three years. This strongly indicates that awareness of the benefits of working capital and cash management improvement has been elevated beyond the treasury to the office of the CEO.
But while corporate profits may be soaring, corporations are still overlooking billions in casha staggering $460 billion in the U.S. and some $570 million (¬469 million) in Europe. This enormous sum is literally stuck in transit, a result of inefficient receivables, payables and inventory practices that could be reclaimed with relatively little investment.
Hackett-REL, which is part of The Hackett Group, a strategic advisory firm, calculates that in the U.S. alone, getting this excess under control would reduce total net debt by 29 percent, increase net profit up to 11 percent and improve return on capital employed (ROCE) from 13.9 percent to 15.1 percent.
Liberating the billions in cash trapped on the balance sheet is easier than one may think. Dell Inc., for instancelauded for overall strong corporate management and working capital performancebuilds a computer only when it has received payment for an order, and doesn’t pay its own suppliers for an agreed-upon period of time thereafter. As a result, Dell enjoys negative working capital and, the more it grows, the more its suppliers finance its growth.
Not all companies can operate like Dell, but most can improve their working capital position by at least 20 percent over time if they pay attention to the following list of cash management do’s and don’ts:
1) Get educated. There is more to working capital management than simply forcing debtors to pay as quickly as possible, delay paying suppliers as long as possible and keep stock levels as lean as possible. A properly conceived and executed improvement program will certainly focus on optimizing each of these components, but also, it will deliver additional benefits that extend far beyond operational rewards. All this underscores the need for ambitious executives to integrate working capital management into their strategic and tactical thinking, rather than view it as an extraneous added bonus.
2) Institute dispute management protocols. Consider a case where a company’s working capital is deteriorating due to an increase in past-due accounts receivable (A/R). A review of the past-due A/R illustrates a high level of customer disputes, which are taking on average of 30 days to resolve and consuming significant amounts of sales, order-entry and cash collectors’ time.
By tackling the root cause of the disputesin this case, poor adherence to pricing policiesthe company can eliminate the disputes, thereby improving customer service. Established dispute-management protocols free up time for sales, order-entry and cash collections’ personnel to be more effective at their designated roles, and they also will increase productivity, reduce operating costs and potentially boost sales. And finally, days payable outstanding (DPO) and working capital will improve, as customers won’t have reason to hold payment.
This example illustrates how working capital is one of the best indicators of underlying inefficiency within an organization and why it is critical that senior executives remain focused on addressing the primary causes of working capital excesses to control operating costs and remain competitive.
3) Facilitate collaborative customer management. One of the most important cash management and working capital strategies that executivesCFOs and treasurers, as well as CEOscan employ is to avoid thinking linearly and concerning themselves solely with their own company’s needs. If it is feasible to collaborate with customers to help them plan their inventory requirements more efficiently, it may be possible to match your production to their consumption, efficiently and cost-effectively, and replicate this collaboration with your suppliers.
The resulting implications for inventory levels can be massive. By aligning ordering, production and distribution processes, companies can increase inherent efficiency and achieve direct cost savings almost instantly. At this point, payment terms can be most effectively negotiated.
4) Educate personnel, customers and suppliers. A business imperative should be to educate staff to consider the trade-offs between various 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 instead of pushing for extended terms – particularly in cases of long lead-time items or those that require high minimum-order quantities.
The same can hold true for customers. Would vendor-managed inventory at a customer site provide you the insight into true usage to better plan your own production? It is important to remember, however, that this is not the solution for all products, and it should be evaluated on a case-by-case basis.
5) Agree to formal terms with suppliers and customers and document carefully. This step cannot be stressed enough. Terms must be kept up to date and communicated to employees throughout the organization, especially to those involved in the customer-to-cash and purchase-to-pay processes; this includes your sales organization.
Avoid prolific new product introductions without first establishing a clear product-range management strategy. Whether in the consumer products or aluminum extrusions business, many companies rely heavily on new products to maintain and grow market share. However, poor product-range management creates inefficiency in the supply chain, as companies must support old products with inventory and manufacturing capability. This increases operating costs and exposes the company to obsolete inventory.
6) Don’t forget to collect your cash. This may sound obvious, but many businesses fail to implement effective ongoing collection procedures to prevent excess overdue funds or build-up of old debts. Customers should be asked if invoices have been received and are clear to pay and, if not, to identify the problems preventing timely payment. Confirm and reconfirm the credit terms. 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.
7) Steer clear of arbitrary top-down targets. Too many companies, for example, impose a 10 percent reduction in working capital for each division that fails to take into account the realistic reduction opportunities within each division. This can result in goals that de-motivate employees by establishing impossible targets, creating severe unintended consequences. Instead, try to balance top-down with bottom-up intelligence when setting objectives.
8) Establish targets that foster desired behaviors. Many companies will incent collections staff to minimize A/R over 60 days outstanding when, in fact, they should reward those who collect A/R within the agreed-upon time period. After all, what would stop someone from delaying collections activities until after 60 days when they can expect to be rewarded? Likewise, a purchasing manager may be driven by the purchase price and rewarded for buying when prices are low, but this provides no incentive to manage lot sizes and order frequency to minimize inventory.
9) Do not assume all answers can 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. Approximately 75 percent of the issues that impact cash flow are internally generated.
10) Treat suppliers as you would like customers to treat you. Far greater cash flow benefits can be realized by strategically leveraging your relationship with suppliers and customers. A supplier is more likely to support you in the case of emergency if you have treated them fairly, and, likewise, a customer will be willing to forgive a mistake if you have a strong working relationship.
That said, also realize that each customer is unique. Utilize segmentation tactics to split your customers and suppliers into similar groups. For customers, segmentation may be based on criteria including, profitability, sales, A/R size, past-due debt, average order size and frequency. Once segmentation is complete, it is important to define strategies for each segment based around the segmentation criteria and your strategic goals.
For example, you should minimize the management cost for low-margin customers by changing service levels, automating interaction, etc. Finally, allocate your resources according to the segmentation, with the aim of maximizing value.
11) Celebrate success in hitting targets. Emphasize the actions that helped you get there. Ask your people to remember what it felt like when they hit the target so they can motivate themselves to hit it again.
Following these do’s and don’ts will allow companies to optimize cash and highlight internal inefficiencies that must be remedied to better serve customers. Moreover, these cash management best practices will enable companies to build stronger partnerships with suppliers across the total working capital value chainultimately, translating into improved bottom-line results.
This article originally appeared in gtnews and was written by Andrew Ashby, President, Europe for The Hackett Group and Hackett-REL
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