Treasury Today Country Profiles in association with Citi

Why working capital KPIs aren’t cutting it

Keeping tabs on key treasury KPIs used to be a relatively straight-forward business. Three metrics – days sales outstanding (DSO), days payables outstanding (DPO) and days inventory outstanding (DIO) – were thought to provide treasurers with an accurate measure of their working capital efficiency. Adopting such metrics was also seen as a critical step on the way to achieving the Holy Grail: best practice in cash flow – both in the management and forecasting disciplines.

But today, organisations with a global reach, or even just reporting units in other countries, are finding that such metrics can be both inaccurate and misleading. In fact, decisions that are being made on the back of these traditional KPIs (such as reducing working capital) could potentially damage the organisation’s ability to do business.

Not fit for purpose?

“For instance the fact that terms and conditions for payments/receipts and methods of payment, for both purchases and sales, vary by country may mean that any averaging of DSO/DPO that occurs at the treasury function level can severely detract from the performance of a subsidiary,” says John Mardle, Managing Director of CashPerform.

According to Mardle, another concern is that the traditional DIO metric does not adequately allow for the complex logistics arrangements that have beset the area of ‘inventory ownership’. In other words, when does a company actually take ownership of the goods?

Furthermore the grey area of ‘work in progress’ impacts the all-encompassing ‘inventory’ statistic: “The traditional approach of recording revenues and profits in line with the percentage of costs (POC) without recognising the amount of cash actually received against invoices raised means that in this credit restricted/cash deficient climate, many work in progress accounts falling within the inventory category of the balance sheet, are in fact masking costs that cannot be billed. Or, if billed, they are rejected by the customer/client as being outside of the agreed commercial terms of the contract,” says Mardle.

This then causes revenues/profits to be adjusted (usually downwards) and causes substantial write-offs of work in progress – once regarded as an asset by accountants and now possibly regarded as a liability.

“Ageing of customers’/suppliers’ invoices and credit worthiness of both customers and suppliers are areas that now impact working capital as the traditional approaches to understanding DSO and DPO – as calculated using days in specified periods – does not take into account seasonal fluctuations,” continues Mardle. For example, the travel industry is busy in the UK during August but in Australia the busiest period is December. Again, the Christmas period in some countries is only four days long whereas in others it is 14 days long for some industries/sectors. He believes that KPIs are needed not just within the treasury department, but within procurement and credit control/sales functions to ensure that the accuracy of such reports is closely monitored, in particular if an organisation’s customers/suppliers are seasonal or cyclical, as described above.

A sign of the times

Elsewhere, “With tougher economic conditions we have seen the need to dig deeper down than the traditional DPO, DSO and DIO metrics. These metrics need to be enhanced to identify the real issues affecting them – this means greater scrutiny of working capital processes,” says Mardle.

This has been brought home by the geopolitical upheavals and natural disasters that have taken place recently – namely, the earthquake and subsequent nuclear panic in Japan, the world-wide shortage of natural resources, and the Arab Spring. All of which make traditional methods of valuing and understanding working capital much more difficult. So what is the answer?

“By putting renewed emphasis on the key ‘drivers’ of working capital management throughout an organisation, corporates can enhance the accuracy of their treasury forecasting and improve the working capital initiatives,” advises Mardle. This should allow the function to deliver the much-needed cash conversion cycle efficiency that so many CFOs crave.

These key drivers can be as simple as the number of returned invoices (invoices that have included insufficient or incorrect information for example) that a particular supplier has incurred. “When the granularity of these invoices is fully mapped, it is often the case that the ‘internal supply chain’ has flaws – these may include accepting copies of GRNs (goods received notes) or a complex rebate/discount structure that the internal systems cannot cope with,” says Mardle.

And if traditional working capital KPIs are so far off the mark, one can’t help but wonder which other treasury metrics are underperforming.