The Internet is one step in a long transformation, which dates back to the telegraph, and which we call the "information logistics" revolution. It is all about exchanging information electronically instead of on paper or in person. The result is a long-term decline in the cost and complexity of interactions between economic actors. The progression from telegraph, to telephone, to Internet is largely one of bandwidth and the convergence of networks.
Logistics, of course, is the art and science of moving things from one place to another. Until the last century, the great constraint on economic interaction was the time and cost involved in physical logistics. Under sail, five weeks was a good passage from New York to Liverpool. Land transportation was far worse.
The revolution in "physical logistics" represented by the railroad, motor vehicles, and aviation has changed all that. But optimizing physical logistics was impossible beyond a certain point before better information logistics were applied to the problem. Electronic data interchange (EDI) and now the Internet have allowed far more efficient information exchange between suppliers, manufacturers, distributors, and customers. This improvement in information logistics has translated directly into better physical logistics.
Re-engineering the Financial Supply Chain
Turning to working capital and the cash cycle, we can observe how the reduction of information float in physical logistics has taken friction and working capital out of the value chain. Unfortunately, it is also clear that corporations have made far more progress attacking the physical component of working capital than they have in attacking its purely financial component. The proxy for physical working capital is typically inventory to sales; the proxy for financial working capital is receivables to sales.
Looking at the corporate cash cycle from purchase to pay in very simple terms, physical working capital was a larger item in the U.S. corporate balance sheet in 1980 than was financial working capital. Between then and the end of last year, the inventory turnover period was reduced from 73 days to 48 days, a net saving of 25 days, while receivables turnover moved down only from 68 days to 57 days. Not only has physical inventory gone from being a larger component of working capital in the economy to a smaller component over the last 20 years, but it is also declining at over twice the rate, 34 percent as opposed to 16 percent.
Business has done a very good job of creating clarity between trading partners in the physical supply chain. Using EDI and more recently the Internet, firms have leveraged the information-logistics revolution — the ability to exchange and process ever-increasing volumes of information between economic actors at ever decreasing cost — to achieve just-in-time procurement manufacturing and distribution. Increasingly, they are building linkages between their own internal information management environments, typically ERP systems, and those of their suppliers and customers. Many initiatives are underway to move large categories or procurement, especially MRO, onto digital exchanges. Exchanges for engineered goods and highly specified materials like steel and chemicals are well advanced.
Why the Holdup in Finance?
Where business has done a less effective job is in leveraging the information-logistics revolution to attack financial working capital tied up in the purchase-to-pay cycle. This is true even though the task of linking the physical value chain involves integrating very complex information flows within and between thousands of firms, while integrating financial accounting information is relatively simple.
Why? The key factor is not the limitations of technology per se. More than enough information exchange and processing capability is in place to make radical improvements achievable. The real problem is a misalignment of power and focus, which makes the buyer side in business-to-business transactions — the side that has driven efficiencies in physical working capital — far less motivated to adopt the same mechanisms to attack financial working capital.
Put starkly, buyers hold the upper hand in almost any commercial relationship. Absent a monopoly, buyers have choices, sellers have competitors. Buyers have every motive to create rich information transparency — that is, clarity — between their own operations and those of their suppliers. To date, however, they have had no such motivation to create clarity at the level of accounts receivable/accounts payable interaction with their suppliers.
The reason is simple: Financial working capital is traditionally a zero-sum game. The seller has to finance his buyer about 90 percent of the time. There is more working capital finance in corporate balance sheets than in the banking system for the simple reason that from a buyer's perspective, it is free.
Of course, it is not free. The seller's cost of financing receivables is an element of his cost of goods sold to the buyer. But that is not a cost that is visible in the buyer's accounting. His books look better to the degree his payables are larger and slower than his receivables. In fact, if aggressive enough, a firm can run on negative working capital, effectively financed by its suppliers and customers.
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