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Title Managing Cash In Crisis - Working Capital The Hidden Treasure
Issue No. 2/2009 - Governing the company in difficult times
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Managing Cash In Crisis Working Capital The Hidden Treasure

By Alvin CY Tan

 

If we were to ask if you wanted interest-free cash without any hidden catches attached, it is likely that there would be unanimous take up in this present climate. The question is – is there such a source of cash available out there?

 

This hidden treasure can be found and derived from liberating cash from a company’s own working capital. The advantage of tapping into working capital value creation is that it is one of the cheapest source of liquidity and the easiest value creation levers to pull. Concurrently, an improvement in working capital will reduce exposure to bad debts and slow inventory as it improves process efficiency and effectiveness, which enhance predictability of and improve cash flow forecasting.

 

The idea of improving a business working capital to free up cash is not new but it is only catching on recently as liquidity dries up. To a lot of people, working capital is basically an accounting number, consisting of accounts receivables, accounts payable and inventory. The perception is that to improve a company’s working capital position, all they need to do is collect faster, pay slower and reduce the inventory holding. There may be some truth to these perceptions but how do you ensure:

 

The working capital improvements

1. are sustainable in your company?

2. There is clear visibility of cash flow?

3. Cash flow is properly managed to run the business, whereby you do not end up “squeezing” your suppliers until they can no longer support you and most importantly, to ensure that customers’ service level are not compromised? There are internal and external factors that affect working capital. The focus should be on internal factors that are within the control of the business. There is a need to look at it from an end to end process starting from “sales to quote management” all the way to “cash allocation” for the receivables; “procurement strategy, budget and forecast process” to “payment issuance and cash management” for payable; and finally for inventory, “product range management’ to “finished goods warehousing, logistics and returns” (Refer to diagram A for end to end processes for working capital management).

 

To demonstrate why the “Working capital building blocks” cannot be ignored or neglected, please take a look at an illustration at the end of the article. Working capital is an effective indicator of a company’s operation and financial efficiency and effectiveness. The closer a company is to their “best possible” situation (best possible day sales outstanding, best possible day payables outstanding and best possible day inventory outstanding), the better the company can focus on developing its core business. By managing the drivers of working capital properly, a company will be able to reap significant operating cost and customer service improvement, paying attention to the areas mentioned earlier. However, the challenge is in managing and maintaining a balance between conflicting objectives like inventory level versus customer service, payment performance versus strategic importance and stock keeping unit proliferation versus market strategy. As the pace of globalization accelerates, supply chain management will become more and more complex.

 

Customers will also start to consolidate their purchases and leverage it with fewer suppliers to gain economies of scale, and higher discounts and rebates with better terms and service. With advancement in technology and new products, the lifecycle of a product also tends to get shorter causing production planning and inventory management to be increasingly difficult. Thus, a company’s working capital needs to be leaner and be flexible enough to react faster to market conditions and changes, so as to stay ahead of their competitors and be in the game. As the saying goes, “The best place to find a helping hand is at the end of your arm”.

 

Illustration:

 

A typical mid size company starts to experience some cash flow issues as they are seeing a significant increase in their Net Working Capital (NWC = Receivables + Inventories – Payables) as a percentage of their sales.

 

The company’s NWC might in this instance account for about 30 percent of their total sales. The factors that account for such a high level of NWC include:

• Sales not growing in proportion to Accounts Receivable (AR)

• No formal credit control

• High level of AR overdue

• Build up of physical inventory

• Steep increase in price of raw material (commodity item)

• Short payment term for commodity item

 

The company, being aware of the situation, starts to try and reduce their working capital level. Basically, to a lot of businesses, in order to reduce working capital, they will aim to reduce the amount of inventory holdings, collect their AR faster and stretch out the Accounts Payable longer.

 

This might be true in terms of reducing the amount of working capital at a point of time. However, the most important question here is: is this sustainable for the business?

 

Individual department heads are then tasked to achieve the above objectives and goals, which are usually pegged to their key performance indicators (KPIs). Most of the time, these “strategic” goals are set without equipping the department heads with the necessary tools and knowledge on how to go about achieving them.

 

This usually results in some silo behaviors that can affect the overall performance of the company. For example, the production team may want to cut the amount of inventory that they are holding, but the sales people are unhappy as one of their directives is to increase the amount of sales. The sales people are afraid of losing sales as they may not have goods to deliver to the clients. The delivery of raw materials may also become inconsistent as the accounts payable team starts to delay payments and the purchasing team starts to buy on longer terms. The suppliers may no longer give them priority as the business is not as profitable as before. While everybody wants to do their part for the company, they may fail to recognize that their individual departmental action may be a trade-off for another department.

 

The following describes some of the actions that are usually within a company’s control and can be undertaken quickly and simply to ease its cash flow problem in relation to the building blocks of working capital. In addition to these, other actions can and should be taken to facilitate improvements in working capital.

 

a) Analyze the company’s situation and identify gaps or opportunities for improvement. The management team needs to establish a clear and understandable goal with clear policies and requirements between cross-functional roles. Priorities and accountabilities are to be decided to differentiate goals that are high and low value in terms of returns. The management also needs to define clear and simple processes and procedures that are in line with the strategic goal for operations to execute.

 

b) Provide training to staff from various departments at various levels to understand the importance of managing working capital and how it affects the company. This will empower them to understand how their departmental or individual actions can affect other departments’ functions and operations within the company.

 

c) Foster the sharing of information among the various departments and equip staff with tools to achieve “quick wins” for working capital reduction. The key is to let them see the potential and possibilities as a form of motivation.

 

d) Establish a system of measurement to track the progress and sustainability of the efforts. Improvement in working capital should not be at the expense of customer service levels. Cash flow management is more than just managing cash. In fact, when working capital is managed properly and correctly, bad debt exposure should fall, and inventory obsolescence should be reduced with a corresponding decrease in interest costs and increase in customer service levels.

 

The writer is Alvin CY Tan, Senior Manager, Transaction Advisory Services, Ernst & Young Solutions LLP.