7 External Factors that Can Add Risk to Your Working Capital
This blog is Part 3 of a 4 part series on Working Capital.
If we had to put Working Capital variability into a typical function statement, it would look something like this -
F(WC) = ∑n f(i1, i2, i3,…., in) + ∑n f(e1, e2, e3,…., en)
‘i’ denotes internal variables such as size of firm, production cycle, distribution cycle, quality, procurement, collections, payments
‘e’ denotes external variables such as industry, demand, competition, supplier power, buyer power, policy
In my earlier blog, I discussed how Analytics helps influence these internal factors to optimize Working Capital. On the other hand, external factors can throw off even the most carefully laid plans for cash.
While many of these external factors are not controllable, executives still keep a sharp eye on them. Naturally, companies have put in place processes to track such changes in addition to implementing risk management strategies to minimize negative impact. Here are the 7 most critical factors to consider:
#1 – Market conditions: I find that the current global situation is very much on the mind of executives. As both operations as well as supply chains become more global and complex, the risk from market conditions has become higher as well as more difficult to comprehend. Political, environmental and other risks have made ongoing Working Capital planning and analysis critical. The more global the supply chain, the more robust should be the de-risking mechanism of the firm to manage its Working Capital.
#2 – Culture: Cultural aspects need to be taken into account in planning, since the norms for terms and inventory vary by country. For example, both payment and customer terms are traditionally lower in North America than in Western Europe.
#3 – Regulatory environment: Companies must closely monitor changes in governing regulations and policies. In certain industries such as Utilities, country regulations prevent the discontinuation of service due to non-payment, or enforce stringent rules on the time lapse for the same, which impacts receivables.
#4 – Supplier base: Companies in industries with a smaller supplier base find it tough to negotiate good terms with their suppliers. Payment terms are usually shorter and discounts hard to come by in such an environment. Even leading firms in such industries may then rely heavily on personal relationships with their suppliers.
#5 – Competitive threats: The level of competition in an industry significantly impacts receivables. Customer terms are hard to negotiate in highly competitive industries. Cash-needy companies in such industries provide good discounts to persuade customers to pay early. In the current economic environment, companies are putting in ongoing mechanisms to analyze the cost of these discounts versus the interest cost of receiving the payment at the due date while taking cash requirements into account.
#6 – Industry segment: Companies in a more cyclical industry plan their inventory with greater care to handle peaks and troughs. In growth industries, companies keep a higher inventory to capitalize on opportunities. Inventory analysis is focused around reaching the right balance between the amount of excess inventory to be maintained vs. the amount of revenue that can be generated. In shrinking industries, the focus is more on analysis to minimize inventory without losing revenue. Safety stock analysis becomes more important in industries with longer supplier lead times.
#7 – Technology: Technological advances have significantly affected the ability of a firm to optimize its Working Capital. The retail industry is a prime example of this trend. A combination of analytics and technology has empowered the sector, leading to better demand forecasting, channel management, and just in time procurement, all of which have contributed to slashing inventory levels. Cash-focused payment modes have also enabled companies to reduce their Days Sales Outstanding.
With increased globalization, ever changing market conditions, and disruptive technologies, companies need to keep constant guard and ensure risk mitigation strategies to protect cash. Consolidation of data along with analytics that delivers timely information and insights is now enabling executives to keep their eyes on the vitals monitor more easily without losing sleep!