If you survey CFOs across different industry sectors, you’ll find that they consistently strive to improve the efficiency of working capital and the metrics of the cash conversion cycle.
Often, however, there are goal conflicts that decrease the improvement in a company’s working capital and cash conversion cycle. These conflicts stem from the lack of alignment across the operational departments of a company. By taking a few extra steps, a company can better align working capital goals across silos and improve corporate results.
The three vital components in the working capital equation are well known to finance and treasury personnel:
- Days Payable Outstanding (DPO);
- Days Inventory Outstanding (DIO); and
- Days Sales Outstanding (DSO).
The objectives are simple: increase DPO, and shorten DIO and DSO
Reducing DIO, usually managed by the chief operating officer, is considered the toughest area to improve. But over time, companies have dedicated substantial resources to improving the physical supply chain and minimized inventory to safe levels. The need to effectively manage inventory levels is also usually well understood by operations.
The CFO has more control over change in the DPO and DSO metrics. Collecting receivables faster is straightforward, but the sales team may try to boost business by offering longer payment terms to customers and thereby increasing DSO.
In terms of DPO, procurement and sourcing teams may negotiate 30-day payment terms with suppliers because that’s the way “it has always been done.” To be sure, a balance is required to maintain proper corporate performance. But a better understanding of the need to improve working capital and how the improvement benefits the company will help align the goals between finance and operations to meet corporate objectives.
The Three Ts
To remember the three actions to perform to improve working capital performance, think of them as the three Ts: train, target, and provide transactional support.
1. Train. One of the most important tasks is to train and educate non-finance groups in what the value of the target improvement means to the company in terms of capital costs, balance sheet improvement, and ratios. It’s fairly common for a finance manager to sit down with the procurement manager to review individual supplier payment terms in which finance ask questions like “Why are we paying so many suppliers in 15-20 days?”
Sourcing usually replies, “Because it was negotiated that way years ago.” That makes sense within the sourcing silo if one can write checks on the company’s capital account and never overdraw from it. Nobody questions the procurement managers if that’s the case.
The finance manager needs to explain, however, that there’s a cost to paying too fast or collecting too slowly on receivables, and often standardized terms can help set the base benchmark. Balance sheet costs or improvements are less tangible at the operational level. Training and understanding how operational activities roll up to the reported financial results of the company will help align the goals of finance and operations.
2. Target. Stating and assigning working capital targets and drilling down to operational levels are key. Successful companies will assign the working capital goals as key performance indicators in personal performance plans.
Many cases are similar. Finance wants to improve the working capital efficiency of the company, and instructs the operating groups in the company to make improvements in working capital. In turn, they expect results. But one detail may be left out: setting specific targets at the granular level. Once targets are established, monthly or quarterly reviews tracking results to the targets and active feedback from finance is needed on the progress to reinforce the effort. This also helps emphasize management’s commitment to the continued importance of meeting the company’s working capital goals.
3. Provide transactional support. Nominating point people as liaisons between finance and other groups can help bridge the gaps between the goals of the different silos and give transactional support to enable changes to go forward. A point person between finance and sales can assist with customer requests for longer payment terms or vendor financing and help find solutions that don’t increase DSO. A point person between finance and procurement can help negotiate longer payment terms because, even after training, a specialist can provide guidance and negotiate assistance. Having a point person also helps change legacy attitudes towards operational performance, provides transparency into the operational groups, and maintains continual focus on improvement.
Here’s an example of how all this comes together. A finance manager at a large retailer looks at average inventory turns for a specific supplier and sees that the inventory averaged 60 days but that the payment terms to the supplier were 30 days.
By means of finance working together with procurement, the managers were able to explain to the supplier the retailers need to obtain 60-day payment terms in order to pay for the goods at the average time they were being sold in order to reduce reducing carrying costs.
Here’s another example, but from a different industry. Large automotive-parts retailers have one-year inventory cycles. They would never be able to grow if they had to pay suppliers on 30-day terms and finance 335 days of inventory. Working intensively on aligning procurement to implement corporate goals, they can lengthen supplier payment terms to better match the inventory period with the cash cycle.
The fact is that companies, industries, and circumstances can change. Historically, there may have been plenty of cash and fewer competitors, and financial metrics were not a major focus of companies or investors.
Fast forward to 2015. Increased competition, market headwinds, or a change in a company’s situation may create an imperative to improve financial results with a more efficient use of capital. Successful improvement in reaching working capital goals will mean less cash deployed in operations, more capital available for business acquisitions, investment in new products or manufacturing, and/or returning capital to shareholders. It all begins by aligning and tracking working capital goals across the organization.
Erik Wanberg is a managing director at Wells Fargo Capital Finance.