Edition 38, Finance

Does your Business Operate with a Mentality of Strengthening Working Capital?

By: Luis Manuel Gomezchico and Francisco Alvarado
Accenture

You survived the crisis… now what?

During an economic crisis, when credit markets shrink, many companies quickly change their strategy to maintain their working capital. With an eye to the short term, they may take actions like delaying payment to vendors as much as possible, while trying to make payments right at the deadline, or minimize inventory restocking. All of this in order to scrape together as much cash as possible to keep operations going. But we know that these actions are not sustainable.

When the crisis is over, the challenge faced by many organizations has less to do with survival than how to improve their working capital to fund investment and resume growth. To do so, they will need to introduce actions that are sustainable in the medium and long term, to manage their inventories and accounts receivable and payable processes in order to have the right impact on their working capital (Figure 1).

Figure 1.

Figure 1. Examples of actions that help improve working capital

Avoid the confusion of having to choose between cash and effective working capital management. Successful companies adopt a focus on working capital management even when they have enough cash for the short term. They understand that working capital is one of the largest and most accessible sources of funding, a source that must be fed regardless of their cash situation. Leading companies are more likely to establish consistent, sustainable business processes, with a vision of ongoing improvement that will allow them to weather economic cycles. In general, successful companies place more emphasis on working capital when their cash position is strong.

From a more strategic standpoint, working capital management has other benefits besides having more liquidity and less debt, because it gives a company the flexibility to grow and invest, and increases value for shareholders through dividends. If more companies had effectively and consistently managed their working capital over the past decade, they might have been better prepared for the crisis and may not have been forced into a paralyzing battle to obtain liquidity.

Accenture conducted an investigation into cost management in organizations that reveals just this point. It surveyed 1,405 senior executives from major companies in North America and Europe, and found that less than a third of those surveyed said they used inventory reduction and payables and receivables optimization to reduce their costs in 2009 (Figure 2), while layoffs, job elimination, organizational structure changes and employee wage and benefits reduction were the most popular actions taken. Meanwhile, 56% of those surveyed said their cost reduction efforts had no impact on cash flow, or in fact inhibited it.

Figure 2. Most popular cash management actions in 2009

Clearly, effective working capital management requires extensive knowledge of the organization. CFOs and treasurers are greatly concerned with working capital, but in most companies, the commitment to improving this capital diminishes in the business units and operating departments.

Taking working capital management seriously means making it part of the operating processes in mentality of the corporation, and not treating it as if it were a one-time exercise. This attitude can be incorporated into corporate culture if it is introduced at all levels, considering its impact on daily and strategic decision-making. Working capital should also be continuously mentioned in corporate communications. Working capital targets even should be incorporated into corporate metrics, performance indicators and bonus packages.

In order for these changes to be sustainable, organizations must be prepared to take the necessary changes in business processes all the way down to the systems level. Luckily, changes in attitudes, processes and systems to improve working capital can help improve other aspects of daily operations. For example, process and technology changes intended to strengthen receivables collection normally improve customer response times and promote effective conflict resolution. Better service means greater client satisfaction and, therefore, greater willingness to pay on time.

Through research and direct experience, Accenture identified six principles that have helped leading companies in their working capital management.

1. Recalibrate expectations through close performance management

Working capital policy should be a priority; but the policy is just the beginning. Top management will have to underscore this working capital priority by communicating and promoting the program until operating managers are convinced of its importance.

Top executives must also be prepared to settle conflicts that may arise between business areas or units during implementation of the changes in processes and structures.

A common error in introducing working capital policies is to not include all levels of the organization, and particularly the affected departments, for example, Sales. Ignoring the priorities of the parties most interested reduces consensus and weakens impetus, undermining the firm’s capacity to introduce a broad-based change. The mentality of sales, for example, should change from “every sale is good” to “sell to high-quality clients that supply the expected level of returns.”

As for governance mechanisms, performance metrics should be included that are broad and deep enough to track processes it in detail, while detecting low-yield areas. An executive or area must be created and put in charge of continuous, structured improvement, and with operating priorities, to deal with areas that need most attention. Finally, when working capital optimization goals are met, the achievement should be publicized constantly in communiqués from top management.

2. Identify high-impact problems and measure them appropriately

This principle should be obvious, but the reality is that many organizations address working capital issues with excessively broad or ambitious programs, without first understanding their greatest opportunities. This generally leads to disappointment, or even abandonment of the effort.

Working capital involves so many different aspects that executives must begin with an exhaustive review of the business areas that contribute to it, from procurement to vendor payments, to product delivery, billing and collection. To understand what aspects of operation currently inhibit working capital, it is useful to prepare and test a set of hypotheses about the main causes of these limitations.

It is important to have precise and up-to-date data, combined with interviews of operating managers, to analyze processes and discover the causes of working capital problems. The best is to have a multifunctional team in charge of this analysis, which should incorporate the finance area, supply chain, business units, sales force, external distributors and, in many cases, vendors. The facts (like “we need 60 days delivery terms to go from procurement to production, while our competitors need only 30, and that costs 100 million”) should serve as motivation to close these gaps.

Issues should be prioritized by financial impact and by viability of the proposed changes. Often, we find one or two areas present the greatest opportunities. For example, with accounts receivable, and analysis of the client database may reveal that the greatest opportunity is in geographic markets, and businesses, or in big clients.

Once a solution is found take advantage of an opportunity in a specific area, that solution is deployed first in the areas of greatest impact and then extended to other segments with a small incremental cost.

3. Select the right performance indicators

To establish priorities and continued improvements, successful companies set working capital goals by company, department, team, and even, when necessary, individually. They also assign a person to be in charge of each target.

This important to set the right goals. Often, companies measure and select the company’s average as their target, instead of breaking down the data, which may be more interesting and significant. For example, management knows sales days in the organizational portfolio, but do they know what affects the performance of this metric: the contribution of the sales terms, the collection process or other factors? If it is based on annual average or general indicator, it may not indicate what is happening right now or in specific parts of the business. Measuring in general terms can obscure variations in performance by region or by country, making it more difficult to optimize working capital.

An appropriate number of regularly monitored performance metrics can help prevent the emergence of new problems. Keeping a scorecard can help management track the most important metrics: five indicators per issue, receivables, payables and inventories. Ideally, metrics are applied at the organizational level, and to each region and business unit. The indicators used should inform management of the status of operations, and the average time it takes to resolve a dispute or deliver an invoice, the number of invoices paid within the term or discounts obtained by the purchasing department. The goal is to help predict future performance.

What is the best possible working capital performance? Comparing a company against others in the same industry may provide an initial estimate of potential performance of the organization, but it is not enough. We must look for the best possible results, given the business model. For example, a pharmaceutical company that wants to improve its performance in raw material storage must not only compare itself against the industry but may study cold storage among the leading dairy product manufacturers.

4. Adjust incentives

Bonuses, commissions and other forms of compensation should correspond to the achievement of working capital goals. In sales, an effective but little-used practice is to tie commissions to what is actually collected, instead of agreed-upon sales.

For bonus incentive programs, in which traditionally payments are determined according to income, the company may add a cash flow component to the bonus formula.

In recent years, Accenture has worked with various clients to include cash flow in their bonus programs. These plans, applied to individuals throughout the organization, have been effective on their own, because they have raised awareness of the impact of working capital in daily decision-making and encouraged cash flow improvements.

5. Adopt a segmented focus for implementation

The company will very likely encounter initial resistance to the extensive changes needed to go from support to optimization of working capital, due to the number of areas and positions affected. That’s why it is important to analyze the client and vendor bases, define significant segments, and chart a plan for each segment.

For example, suppliers of very accessible items or very small vendors may be asked to accept a longer payment terms without risking operations, because it would be easy to change them if necessary. In contrast, with more strategic vendors, it may be appropriate to adopt a focus of partnership or even to collaborate in creating a payment structure that maximizes the benefits of the business for both parties. The same logic applies to clients: impose stricter payment or collection terms on non-core clients which have less of an impact on general performance, and be more flexible with terms for strategic or high-value clients. As for inventory, it is a good idea to plan demand and variability in order to establish priorities for the purchase of raw materials and storage of finished products.

A segmented focus can only be successful with the active and concerted involvement of all the functional groups that come into contact with clients and vendors. If the sales area, for example, cannot help comply with stricter collection policy, the policy will not work in practice. It is the job of top management to guarantee multifunctional cooperation to optimize working capital.

The company must understand in advance the impact on the business and the resistance it may face from clients and vendors, and evaluate beforehand how the organization must change. These are key components of any working capital improvement program. Companies may follow a number of methods to facilitate the transition. For example, they may offer discounts for limited time or launch a more aggressive collection campaign.

6. Evaluate and redesign business processes

Short-term changes in inventory management, payables and receivables policies, are likely to bring only moderate improvements in working capital. Most companies also need to make changes in their operating processes and their systems to ensure long-lasting efficiency and move on to the next level of performance. It may be that they detect the need to give their employees new tools, like improved software and training to strengthen their abilities, apply more sophisticated analytical methods to receivables practices in order to optimize the advantages of offering discounts for on-time payment, or eliminate the discounts altogether, or to modernize supply-chain software to better align the firm’s projections with the real capacities of its suppliers.

Conclusions

Now that many companies have once again set their sights on growth, a big step forward in working capital performance may be a crucial advantage. Improvements to processes, systems and capacities that promote strong working capital management may also encourage high performance in other areas, like more precise planning of demand, on-time product delivery and stronger relationships with suppliers. With the right initiatives, the company can succeed in obtaining a steady flow of free cash flow. Sustained excellence and working capital management can better prepare an organization for ups and downs in the economy, because it strengthens their capacity to survive and prosper in a world of uncertainty and economic volatility.

References

  • Accenture Cost Management, An Aspect of Profit and Cash Optimization Study, 2010.

For more information about working capital management and the contents of this article, write to the authors at: f.alvarado.navarro@accenture.com; luis.gomezchico@accenture.com

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