Treasury Today Country Profiles in association with Citi

Working capital management: filling in the gaps

Since the financial crisis, working capital management has moved up the list of priorities for CFOs and finance directors. With credit remaining expensive and scarce, treasurers are looking within the business for opportunities to release trapped cash. However, sometimes these opportunities are missed, particularly in the area of inventory. We consider some of the ways in which treasurers can maximise the effectiveness of their working capital management.

The rise of working capital management

Working capital management has long been practised as a means of raising finance. However, in recent times it has become ever more popular amongst cash-strapped companies, which have found access to credit restricted and bank financing costly in a post-crisis environment. Effective working capital management is not just for the cash-poor: it can also be used by companies in a better cash position in order to ensure the efficient flow of cash around the business.

The management of working capital involves optimising inventories, accounts receivable and accounts payable, as well as cash. By effectively managing cash flows and overall liquidity, the intention is for a company to reduce its overall working capital requirements. As a result, the company may be able to reduce its need for external funding or maximise yield on positive balances.

In a recent survey by REL, it was discovered that, among Europe’s top 1,000 public companies (excluding financial institutions), overall days working capital deteriorated by 6.3% from 2008 to 2009, from 44 days to 47 days. In a breakdown of the results:

  • Days sales outstanding (DSO) increased to 55 days – a 7.7% deterioration.

  • Days inventory outstanding (DIO) increased to 39 days – a 5.0% deterioration.

  • Days payables outstanding (DPO) increased to 47 days – a 6.8% improvement.

The report also notes that while five of the top ten companies in the survey did improve their days working capital, they did so by an average of only 13%, while the remaining five companies’ days working capital deteriorated by a staggering 60% on average.

So, where are companies missing out? In this article we look at how companies should be making the most of the opportunities available in the area of working capital management, including the common pitfalls, such as ignoring inventory and neglecting working capital in times of prosperity.

Working capital metrics

Working capital is defined as:

Working capital = current assets current liabilities

It is usually measured with the following three metrics:

  1. Days Sales Outstanding (DSO).

    This relates to the company’s accounts receivable and is defined as the average number of days taken by a company to collect payment from a completed sale. The lower the DSO, the faster payment is collected, and the sooner the cash can be used for other purposes.

  2. Days Payables Outstanding (DPO).

    This is based on the number of days taken by a company to pay its creditors. From a working capital perspective, this should ideally be as high as possible.

  3. Days Inventory Outstanding (DIO).

    This relates to the number of days taken to convert inventory into sales. A lower DIO means that inventory is being converted into sales more quickly, which in turn means that less inventory can be held and therefore that less working capital needs to be tied up in inventory.

A company’s cash conversion cycle (CCC) is defined as the number of days taken to convert cash invested in the manufacturing process back into cash after the manufactured goods are sold.

CCC is calculated as follows:

CCC = DIO + DSO DPO

The shorter the CCC, the shorter the period during which capital is ‘locked up’. The CCC can be shortened by reducing DIO, reducing DSO or increasing DPO. In some cases it is possible for a company to have a negative CCC, meaning that it receives payment from customers for finished goods before suppliers are paid for the raw materials required to produce them.

Days Working Capital (DWC), meanwhile, measures the number of days a company takes to convert working capital into revenue. DWC is calculated as follows:

DWC = DIO + DSO DPO Total revenue / 365

The lower the figure, the more efficiently working capital is being turned into revenue.

Not just for the cash poor

As a means of reducing the company’s need for external financing, the importance of working capital management has significantly increased since the outbreak of the financial crisis. In a low interest rate environment, effective working capital management is crucial for cash rich companies as well as cash poor.

Roger Blackburn, Treasurer, Kellogg Europe, goes so far as to say, “Any business not currently focused on managing its cash resources and working capital will likely not be in business in five to ten years’ time.” He also points out that, just because a company is cash rich today, it may not necessarily remain so, as it will inevitably have to face increased competition from new entrants into its market sector.

“Any business not currently focused on managing its cash resources and working capital will likely not be in business in five to ten years’ time.”

“Indeed, once predators perceive the opportunities being overlooked by current management, the company will likely be at risk of a leveraged buy-out.” Effective working capital management is arguably crucial to the survival of any company, regardless of its cash position.

Vanessa Manning, Head of Market Management, EMEA, RBS, agrees that working capital management is a top priority even for cash rich companies. In a recent survey conducted by RBS, in which 200 corporates were polled, of those companies that are cash rich:

  • More than 55% are looking to take significant action to improve the investment return on cash.

  • More than 50% want to reduce their bank financing costs.

  • Almost 60% intend to implement programmes that will result in significant DPO and DSO improvement.

Ignoring inventory?

The key areas that can be tackled from a working capital management perspective are:

  1. Payables.
  2. Receivables.
  3. Inventory.

Treasurers’ working capital management efforts have traditionally focused on payables and receivables, which we discuss in more detail in our Best Practice Handbook, Managing the Financial Supply Chain, published this month. As Blackburn observes, however, “Ignoring the opportunities in inventory management is like operating with one hand tied behind your back.”

Inventory refers to physical assets, including raw materials, work in progress and finished goods still held at the company. Efficient inventory management depends on the accuracy of forecasts. If demand for a particular product can be forecast accurately, it will not be necessary to hold a significant surplus of inventory. However, as Blackburn points out, this can conflict with the instincts of warehouse staff who like to see their shelves filled to capacity.

In fact, inventory management is one of the areas where companies can most easily find efficiency savings, since it is largely tackled internally. However, it is important to appreciate the ways in which internal targets may materially impact external parties. John Mardle, Partner, Develin, cites an example of a CFO who called for a 10% decrease in inventory within three months: “The emphasis was purely on cost reduction of materials/services coming into the company.

No thought was given in most cases to the types of inventory, where the major inventory value was (ie in Puerto Rico or in Australia), or indeed what category it was (ie work in progress, finished goods, etc). The results were disastrous, with suppliers responding in various ways, such as reducing supply, increasing hauling and packaging costs, introducing minimum batch requirements and time-framed deliveries, all of which actually caused inventory costs to rise.”

Who’s in charge?

Inventory management can often lead to internal disagreement within a company, with the treasury and CFO wanting to hold as little as possible, procurement wanting to make the most of discounts available for bulk purchases, and sales wanting high levels of stock to ensure customers receive their products quickly. Therefore, an effective working capital management solution will benefit from the active involvement of all areas of the business – from purchasing (payables), to logistics (inventory), to sales (receivables).

“At Knorr-Bremse,” says Dr Sigurd Dahrendorf, Head of Corporate Treasury, “we have a process named SCE (Supply Chain Excellence) where all these participants work together in a permanent project under personal surveillance of the CEO and CFO.”

Demand chain management is one technique which can be applied in this area. This addresses all the key issues originating from the point of contact with the customer, through to order fulfilment and then to replenishment of stocks to satisfy expected demand.

Although the CFO or finance director may be in the driving seat, working capital management cannot be viewed as solely the job of the finance department. To encourage greater co-operation from other areas of the business, which might see the demands of working capital efficiency as contrary to their department’s preferred approach, it could be worth introducing a working capital target into the company’s overall bonus or variable pay structure. Any related product proposals or capital expenditure requests should also outline their implications for working capital.

“…top down is not enough, it needs to be from the bottom up to get local stakeholder buy-in.”

Another important way of ensuring that the working capital strategy is adhered to throughout the company is by introducing key performance indicators (KPIs) that relate to the main drivers behind the working capital initiatives as they are rolled out across the group. KPIs for working capital have traditionally been, and continue to be, based around DSO, DPO and DIO. CCC is also increasing in focus. KPIs have two key objectives. Firstly they provide a means for continuous improvement and ensure that both central treasury and local managers are aligned with the group’s strategy and targets. Secondly they can provide a means of benchmarking the company’s treasury team against its peers.

“This top down approach, in terms of the treasury or the CFO setting these KPIs, should always take into account the complete context of treasury – its processes, goals and interfaces,” observes Manning. “But top down is just not enough; it also needs to be from the bottom up to get local stakeholder buy-in.”

The role of banks

Banks can support corporates looking to improve their working capital management in a variety of ways. Banks’ advisory services can provide insight into what other corporates are doing in the working capital space, which can provide a useful opportunity to benchmark against peers and discover possible means of improvement.

In terms of products, in the area of inventory there are products available which can allow treasurers to keep inventory off-balance sheet. In other words, the bank buys inventory on the company’s behalf by using a special purpose vehicle (SPV) and sells it on to the producing company on demand.

Definition – Special purpose vehicle

A special purpose vehicle (SPV) is an entity whose operations are limited to the acquisition and financing of specific assets. Their legal structure ensures that their obligations are safe even if the parent company goes bankrupt, which means they can be used to finance large projects without putting the company at risk.

Supply chain finance products have also been given particular attention in recent years. However, criticisms have been voiced that the banks’ services in this area are merely repackaged products, and that supply chain offerings such as reverse factoring are in reality just a means of increasing a bank’s security for its lending. “Banks did initially market new approaches to financing working capital,” recalls Mardle, “but then rapidly withdrew certain products as they found they were not sustainable either for themselves or for their own customers! The major reasons for this were the lack of understanding regarding levels of credit required, the quality of the credit and then the collateral required to support the package.”

Nevertheless, supply chain finance products continue to grow in popularity as a means of enabling suppliers to receive early payment while allowing the corporate to extend its payment terms. A report by Demica, published in June 2010, found that 25% of 1,500 respondents had been taking part in a supply chain finance programme for several years and that 10% had joined such a programme in the last year.

Technology

One area in which banks are currently investing is the technology to facilitate tighter control and visibility over working capital. Corporates can take advantage of this in order to achieve end-to-end visibility. Manning observes that technology is an important part of a bank’s offering in the working capital management space: “Innovative technology features very heavily in our approach to delivering what clients want – which is visibility, standardisation and efficiencies across their physical and financial value chains.” New technology allows for much greater automation, which in turn improves STP and can consequently bring down transaction costs. Demand for outsourcing various services is increasing and Software as a Service (SaaS) solutions can provide corporates with a much more cost effective solution for managing their working capital.

Treasurers should consider all the available options when addressing their working capital management strategy. It is therefore worth giving banks the opportunity to demonstrate how they can help, whether this is simply by means of their advisory services, or through specific products or technology offerings.

Going forward

While the financial crisis has brought working capital management centre stage, this is not a new practice. According to Sigurd Dahrendorf, “Working capital management is always a very important issue, not only during crisis. At Knorr-Bremse we give this matter special top management attention since it is an immense source of cash generation, regardless of whether the company is cash rich or not.”

Now that the benefits have been more widely acknowledged, it is likely that working capital management will remain a hot topic for some time to come, even beyond recovery from the financial crisis. Treasurers are becoming increasingly focused on improving efficiency in all areas of cash management, and for companies that are weighed down by inefficient and time-consuming processes, now is the time to strip them away.

Checklist

Working capital management

  • Get involved

    Ensure the entire company is on board – not just the finance department.

  • WCM KPIs

    Implement KPIs relating to the key drivers behind your working capital management strategy.

  • Reward efforts

    Consider ways to encourage greater co-operation, such as introducing working capital targets to the company’s bonus structure

    Also use KPIs (see above) to incentivise the workforce.

  • Go shopping

    Does your bank offer any products that could help you manage working capital more effectively? What technology does it provide?

  • Start as you mean to go on

    Just because your company is cash rich now, don’t leave working capital management for later when times get hard.

  • Don’t forget inventory

    Managing working capital is about payables, receivables AND inventory.

  • Communicate

    Ensure that suppliers/creditors are made fully aware of how any strategies you implement may affect them.

  • Report on progress

    Produce a regular management commentary on the progress of your working capital management strategy to inform banks and financial institutions of the sustainability of the company’s cash flow.

  • Revisit risk

    Be aware of when working capital refinancing commitments come due, as the temporary restriction of cash flow could be disastrous.

  • Find the silver lining

    Be proactive in the event of economic slowdown by taking the opportunity to review operations and cut out inefficiencies.

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