From the June Special Report issue of Treasury & Risk magazine

Working Capital Management: There Goes the Rigor

Improved working capital provides sunshine during recession’s rain showers.

From a corporate perspective, the dark clouds of the recession did have one silver lining: Companies improved their working capital performance. With revenue opportunities stalled, if not declining, organizations enhanced their working capital due diligence, growing margins by taking an ax to days sales outstanding, payables outstanding, and inventory.

No sooner did the dark clouds disperse, however, than some companies went back to their old ways of mismanaging working capital, effectively letting go of the rigor. In their eagerness to land new customers, some companies extended payment terms and let inventory levels rise so that they would have enough product in the pipeline and on the shelves to satisfy percolating demand.

Wouldn’t it be better to strike a balance between diligent working capital management and giveaways for revenue opportunities? The answer is yes, but the solutions are not easy. “There is great value in finding some equilibrium,” said Miles Ewing, principal and head of the financial performance management practice at Deloitte Consulting. “But getting there requires metrics, flexibility, and a bit of give and take.”


Bridging the Disconnect

Working capital is one of the best indicators of a company’s financial well-being, but organizations tend to give it the most attention when they’re running a tight ship in volatile seas. “When sales fall, companies put the squeeze on things they can do to widen profit margins,” explains David Wojcik, managing director at JustOne Consultancy, a Hertfordshire, U.K.-based consulting firm specializing in working capital performance. “They try to find savings anywhere they can, and working capital is a great place to find it.”

By conserving working capital, companies can pay off debt, which increases their net margins and pleases shareholders. They can also hoard the cash for opportunistic spending when the economic picture brightens. Or they can release some of the accumulated capital to shareholders as dividends, plunk it down to buy back shares, or stick it in research and development in preparation for better times ahead.

“During tough times, there is a need for companies to operate more efficiently, getting more from less,” said Dan Ginsberg, associate principal at REL Consultancy, a division of The Hackett Group. “And the way to generate more cash revenue is superior working capital performance. Customers are happy because you’re paying on time, suppliers are happy because you’re paying them on time, and investors are happy because you have an efficient supply chain. There is a direct correlation between tight working capital management and shareholder value.”

Not that superior working capital performance is without risk. “Companies will reduce inventory, but it may damage sales if buyers in a B2B environment don’t get product on time and fail to meet their own ‘just-in-time’ obligations,” Wojcik said. “They may try to pay suppliers later, but that can anger the vendors and invite higher prices down the line. They do the opposite with customers, pressuring them to pay earlier, which can have sales repercussions.”

Obviously, a careful approach is important when making substantive working capital alterations in a bleak economy. A similar degree of care also needs to be applied when times improve. “Once companies move into growth mode, the intense need to preserve capital weakens. There is less risk of the company running out of money because of the wide availability of liquidity from the debt and equity markets,” Ginsberg said. “This can cause knee-jerk reactions, such as speculative sales approaches to quickly generate revenue, swinging the pendulum too far the other way.”


Monitoring the Pendulum

One way to measure the pendulum’s gyrations is to maintain a close watch on the sales-working capital metric, which is working capital divided by sales. “The goal should be to keep the metric as stable as possible, whether sales are going up or down,” said Wojcik. “When opportunities are rising quickly, you want to be able to release working capital to invest more money in sales efforts.”

Indeed, a bit of wiggle room is permissible and advisable, Wojcik said. “It’s a good idea to segment customers into different buckets from a receivables standpoint, to have finance working with sales to segment the good customers from the bad ones when it comes to paying on time,” he said. “Pressure should be applied to those who pay late. ‘A deal is a deal,’ you tell them. With suppliers, it’s okay to negotiate longer [payment] terms, so long as it comes with your promise to always pay on time.”

With inventory, he counsels companies to identify the bottlenecks and then segment their effects on different products. “The stuff selling best might require more inventory, but you can keep levels lower for the rest,” Wojcik said.

Ginsberg said such balancing acts are delicate. “Say a company is moving into an entirely new market in an emerging economy in Latin America. To build revenue, it might provide more generous customer terms to get as many new customers as it can. It might also build up inventory because it does not have reliable logistics patterns in place yet. This willingness to be more lenient is good in the short term. But what will eventually happen—to take a page from physics—is an opposite, and equal in magnitude, reversal of fortune,” he said. “At some point, those too-generous customer terms and higher inventory will come back to haunt the company through an increase in accounts receivable and obsolete products, respectively.”


Skin in the Game

To keep companies from wildly swinging the pendulum, Ewing from Deloitte advises tying working capital performance to incentive compensation. “Companies routinely reward salespeople for increasing sales revenue beyond certain projections; they should consider a similar bonus structure to achieve specific working capital management metrics, in this case customer receivables,” he said “The more customers that pay on time, the higher the bonus.”

A shared metric can also be developed to encourage inventory rigor and “stick-to-it” supplier terms, he adds. And if people fall well shy of the goals, that failure should adversely affect their bonus pay. “At the end of the day, there should be a penalty for encouraging too much inventory that can’t be sold,” Ewing said.

Working capital management can be a workout, but the sweat is worth it.

 

Read the June Special Report on Working Capital Management.

Related:
Back to the Grindstone on Working Capital Management
Supply Chain Finance Takes Off
Evolutions in Treasury Centralization
Distributor Finance: A New Strategy to Support Top-Line Growth and Sales into Emerging Markets

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