There’s nothing like a crisis to focus the mind—and to focus the organization on working capital management improvements.
Despite its far-reaching negative impacts, the 2008 global financial crisis proved beneficial to many companies’ working capital management practices. That hard-earned wisdom, combined with subsequent working capital and treasury innovations, will come in handy during the next (or current) downturn. “The lessons of the financial crisis have done a lot of good across most industries,” says C2FO senior vice president, market innovation, Jordan Novak. “During the past 12 years, sophisticated organizations have made impressive progress with regard to treasury technologies, supply chain models, and transportation and logistics approaches.”
Those improvements should help treasury leaders, their key business partners, suppliers, and customers weather the latest downturn—along with trade wars, tsunamis, extreme political volatility, viral outbreaks, and other unexpected disruptions—more effectively than most companies did in 2008 and 2009. Of course, not all companies appear better prepared: 69 percent of small to midsize enterprises (SMEs) based in the U.K. reported experiencing significant pressures on their cash levels in March, in a survey by business finance lender MarketFinance.
To address those types of pressures and ensure that working capital improvements occur during the next 12 to 18 months, treasury leaders should keep in mind the most notable breakthroughs of the past decade, identify specific actions to deploy, and identify challenges likely to prove most problematic.
Supply Chain Finance and Other Post-Crisis Breakthroughs
Numerous improvements to working capital strategies and management practices have been developed and adopted in the past decade. “Advanced analytics have matured greatly since the last recession,” notes Peter Kingma, EY’s Americas working capital lead. Other advances in working capital management strategies and technologies have also been widely adopted since 2008:
The buzzer sounds on the zero-sum game. Many companies, especially those based in North America, have grown more reluctant to reflexively extend supplier payment terms in reaction to economic shocks and localized liquidity crunches. Strategic Treasurer managing partner Craig Jeffery notes that the old-school working capital management approach of “I win and you lose” no longer holds sway. More collaborative and mutually beneficial approaches, such as those offered via supply chain finance, now exist.
The emergence of supply chain finance. SCF marks one of the most important working capital management—and treasury—developments of the past 12 years. SCF solutions, which tend to revolve around a technology platform, get suppliers paid earlier, shortening their days sales outstanding (DSO) without reducing the customer organization’s days payables outstanding (DPO). Thus, SCF technologies, processes, and financial instruments enable organizations on both ends of a transaction to optimize the working capital and liquidity that would otherwise be tied up in the supply chain. Essentially, Jeffery says, SCF enables a company to substantially improve its working capital management “without breaking a trading partner,” thanks to the injection of third-party liquidity.
Managing working capital as an end-to-end process. Jeffery reports that an ongoing focus on improving the end-to-end working capital management process is now recognized by more stakeholders as an efficiency driver for both suppliers and customers. “Triggering inquiries about late payments or calls about how to apply a payment that doesn’t contain details is a massive waste of time for both parties,” he notes, “and optimized communications have become more in vogue.”
Other, related processes have also made strides. The past dozen years have seen a dramatic rise in the number of organizations moving to rolling forecasts instead of annual budgets, according to Steve Player, managing director of The Player Group and of Live Future Ready, a membership organization devoted to moving companies beyond traditional budgeting processes. “Forward-looking forecasts are much more capable of providing useful information about future direction if they are focused solely on providing a best-case estimate of what will likely happen,” Player explains. “Some organizations mistakenly use ‘hope to achieve’ forecasts that reconcile to a budget target but are not based on driver-based metrics. Wishing uncertainty will go away is no substitute for a concrete action plan that can be track for execution and monitored to see if it is achieving the desired result.”
Treasury management systems can generate rolling forecasts by business and deliver a clear picture of which customer relationships consume too much working capital, compared with the operating margins those relationships generate. Other tools can track individual payment patterns and leverage artificial intelligence to greatly increase the accuracy of accounts receivable (A/R) forecasts. Robotics and Internet of Things (IoT) technologies can greatly increase inventory management accuracy and agility. Additionally, says Novak, many companies now use “advanced technologies to pull in, and then analyze, way more data to make their forecasts much more precise.”
Treasury’s increasingly strategic role and relationships. Novak also reports that treasury leaders’ development as strategic business partners has enhanced their companies’ working capital management capabilities. “Finance and treasury leaders have generally grown more adept at bringing everyone together, getting alignment, and driving the business forward on the working capital front,” Novak says. “You really need all stakeholders aligned. Otherwise, it’s just treasury bashing their heads into the wall to get something done.”
Treasury’s strategic shift is paying dividends, according to Kingma, who now observes “a much greater appreciation by management, boards, investors, and analysts of the importance of free cash flow.”
4 Working Capital Improvements to Consider
Working capital can be simply defined as current assets minus current liabilities. The fundamental approaches to managing working capital are also relatively straightforward and enduring. A 2012 study of working capital management best practices by benchmarking firm APQC and consulting firm Protiviti identifies several improvement actions that remain relevant today, including:
- Aligning working capital management processes with corporate strategy;
- Cultivating cross-functional engagement;
- Identifying relevant drivers, and related metrics, for working capital management value and risk;
- Deploying supporting technology to increase efficiency and support process improvements; and
- Continuously improving the capability.
The specific approaches and activities used to achieve those goals have changed, but the goals remain the same. That helps explain why the working capital optimization steps that treasury experts currently advocate—which relate to internal collaborations, supplier/customer communications, and metrics recalibrations, among others—center on relationships and communications. Treasury leaders know what needs to be done, and the following approaches can help them execute those steps more effectively:
1. Collaborate internally. Michael Quails, of Deloitte Risk & Financial Advisory’s working capital management practice, encourages corporate treasury and finance teams to work with their commercial-facing and sales and operations planning (S&OP) colleagues to make inventory adjustments that boost working capital. Commercial and operations groups can focus on reducing slow-moving and obsolete (SLOB) stock. In service businesses, Quails notes, “the assets that are underutilized should be liquidated to raise cash, and the sales and operations planning processes should be focused on increasing flexibility in their scheduling to maximize labor efficiency and asset utilization.”
EY’s Kingma agrees with the need for these collaborations. He also notes that treasury and finance leaders should not assume that supply chain operations staff have the right experience to manage a downturn nor that S&OP processes are correctly aligned when actuals begin to swing wildly relative to forecasts.
2. Increase and enhance communications with customers and suppliers. From an A/R perspective, organizations should strive to “maintain credit terms and ensure that customers do not use the down cycle as an excuse to demand longer payment terms,” says Erik Smolders from Deloitte Risk & Financial Advisory’s treasury management practice. “Focus on the credit strength of the customer base, and potentially take mitigating actions, such as credit default swaps or credit insurance, to reduce the exposure to customers with deteriorating credit metrics.”
It is also prudent to recognize that late payments may signal an increasing default risk. The start of a down cycle, Quails notes, represents an opportune time to review customer credit lines and to “right-size” unused customer credit lines to expected sales volumes.
From a payables and credit risk management perspective, Smolders advocates expanding communication with critical suppliers and credit insurers. Those discussions can help vendors respond more efficiently to changing demand levels while maintaining minimum order quantities during a downturn.
3. Scrutinize internal processes. “Evaluating internal processes can make an enormous difference,” Jeffery asserts. When conducting evaluations throughout the cash conversion cycle, Jeffery suggests, treasury teams should home in on timing issues, defects, errors, and exceptions. There may be ways to reduce the time it takes to approve a customer for credit and/or to create and deliver an invoice. Those improvements can expedite the cash conversion process.
Treasury decision-makers can also assess the volume and frequency of order and/or invoice errors, as well as the impacts of those issues. “A defective invoice requires correcting and can add up to 100 percent to the standard terms for payments,” Jeffery adds, “while costing both parties staff time and [reduced] efficiency.”
4. Recalibrate how metrics are monitored and managed. DPO, DSO, days inventory on hand (DIO), and other key measures of working capital performance are often calculated on a quarterly basis, for reporting purposes. That schedule may not be sufficient during a down cycle. Instead, Smolders recommends calculating these key metrics (by business unit) at every month-end close so that performance can be compared with budgets and forecasts. “Business unit controllers should develop, and be held accountable for, the operating cash flow of their business units against budgets and forecasts,” Smolders notes.
Treasury leaders can also ensure that business partners are prepared to quickly implement adjustments and improvements when performance measures dip. For example, companies with significant rebate earnings from suppliers should ensure that rebates are claimed and collected immediately after they’re earned. That agility can help reduce “significant hidden reductions of payment terms for unclaimed rebates,” Smolders reports.
On the other side of the balance sheet, he says, it is vital to ensure that execution of invoicing, cash applications, customer service, and dispute resolution are timely. Slowdowns in those areas can cause DSO metrics to spike.
Treasury and finance leaders can also evaluate larger-scale improvements that require more time and effort, such as expanding the number of business leaders whose incentive compensation structures are tied to free cash flow generation, implementing vendor-managed inventory approaches, revamping sourcing strategy and approaches, and more.
How to Leverage This Downturn?
While many treasury functions and businesses have notched significant strides in working capital management in recent years, several challenges will complicate their ability to optimize working capital during a downturn.
Unexpected disruptions—such as extreme weather events, global trade skirmishes, or the Covid-19 outbreak—can swiftly reduce the ability of suppliers and customers to deliver, pay, or even remain in business. Consolidation tends to intensify during down cycles, which can also create sudden changes to the supply chain. “Consolidation pressures companies to be more competitive with payment terms and offerings, and those shifts can strain inventory levels and create more working capital challenges,” notes Novak.
Those challenges require companies to ensure that their working capital management practices enable the company to react nimbly to unexpected disruptions. “It’s all about flexibility and visibility,” Novak adds.
It’s also about learning from mistakes, and it’s never too early to start leveraging current economic shocks for ways to improve working capital management in the future. “Very few organizations operate a true cash culture,” Kingma points out, “meaning that beyond a few levels of finance, most leaders in the business don’t really understand the balance sheet, nor do they understand the impact of their decisions.”
Upgrading the understanding of working capital management throughout the organization will better prepare a company for the cash flow pressures of subsequent down cycles.
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Eric Krell’s work has appeared previously in Treasury & Risk, as well as Consulting Magazine. He is based in Austin, TX.