Is there a secret sauce for Working Capital?

Author

Divya Kumar

May 28, 2015

This blog is the final installment in a 4-part series on Working Capital.

Probably not! If there was, firms would be lapping it up. In fact, the sauce often needs to be adjusted to the tastes of the target company, country or industry. However, the basic recipe can remain the same. I think of it as a standardized approach to a customized outcome. The Key Performance Indicators (KPIs) of Working Capital for each organization do not differ, the superset of factors that impact them do not differ, but which subset of these can actually be used to impact the Working Capital in a specific organization differs.

Best-in-class companies have adopted certain practices to get this right:

  • Benchmarking: Companies that manage their Working Capital well ideally benchmark themselves against their peers in the industry and outside, and absorb best-in-class practices. Benchmarking usually involves breaking down the cash conversion cycle into Days Payables Outstanding (DPO), Days Sales Outstanding (DSO) and Days Inventory Outstanding (DIO). Typically one area emerges as needy of more focus than others. While learning from their peers’ best practices, they also perform a deep dive analysis on key areas to optimize them. Most importantly, companies that perform benchmarking activities treat this as an ongoing process rather than as a one-off exercise.
     
  •  Matching analysis to objectives: Companies often are not looking for just the plain vanilla objective of optimizing Working Capital. Their objectives are more nuanced and sometimes not even cash related. It is important to define them so that the analysis can match the objective rather than a “one size fits all” approach. To give you an example, in one of my discussions with a CFO, he told me that he has excess cash every quarter and does not need further cash optimization. Instead, he wanted to optimize the payments runs to gain the maximum discount to enhance profitability. In another discussion related to discounts, a CFO wanted to focus on early payments to get discounts in European countries with low interest rates, while paying on time and leaving discounts on the table in some Asian countries with high interest rates. Our cost benefit simulators were thus of more interest to him. Objectives need to be dynamic and analytics needs to be fluid enough to adapt to ever-changing short term and medium term objectives while always keeping sight of the long term objective.
     
  • Translating analysis to outcomes: Best in class firms have clearly defined Working Capital metrics which enable them to drive accountability. Each metric has lead indicators and levers identified that can enable managers to course correct on an ongoing basis. There is a mature and ongoing analytics methodology geared for optimization. These metrics and analysis then receive pride of place in executive reviews so that they can be discussed with a larger forum of leaders who can impact the outcomes. There is also a clear forecasting process linked to the cash strategy in which working capital plays a pivotal role. Firms use the cash release from working capital to pay down debt, finance growth and investments, counter the high external cost of capital, and enhance the liquidity and agility of the business.
     
  • “Handle with care”: Walking the tightrope to determine and maintain the right threshold for Working Capital is tricky. Tradeoffs occur at every stage since the associated risks are high. Lesser credit terms could lead to lost sales while longer supplier terms could lead to lower quality materials being supplied. Lower inventory could lead to stock outs and a balance needs to be struck between maximizing sales and minimizing inventory. Relationships with suppliers and customers cannot be compromised. Companies which follow this practice focus on optimization rather than minimization or maximization and leaders are aware of the impact of their actions.

An Ernst & Young Research survey, measured the “cash opportunity” of companies as compared to their peers in the top quartile of their industry group. They surveyed 1,000 US companies and 1,000 European ones and found that in total, $1.3trillion cash is unnecessarily tied up in Working Capital, amounting to nearly 7% of the companies’ aggregate sales. 35% of the cash was locked up in receivables, 35% in payables and 30% in inventory. It is thus no wonder that Working Capital has come into the spotlight and Analytics around it is gaining tremendous traction.


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