How to make a success of your working capital management initiative
Working capital management is, arguably, the core function of business – making sure that cash flows in and out is absolutely fundamental; it even sounds simple. But in today’s sophisticated, multinational organisational structures, it is actually a hugely complex task.
Vital, but misunderstood
Surveys show time after time that organisations recognise the importance of working capital management. In Protiviti’s 2014 Financial Priorities Survey1, working capital management ranked as a “significant priority” for CFOs. It is easy to see why: companies that manage their capital well benefit from better cash flow. They enjoy greater return on their invested capital. They minimise the cost of borrowing.
But Nordic organisations are having a tough time of it. PwC’s 2013 survey2 of working capital performance found an overall 7% deterioration in working capital ratios in the Nordics, while the rest of Europe improved year on year. Working capital stands on average in the region at a 21% of sales, which for many organisations is too high. And few Nordic organisations are confident enough in their ability to manage working capital to place bets on it: our own 2013 study of financial targets found that only three of the OMX Nordic 40 publish any explicit working capital management target, and only one publishes working capital guidance.
A 2013 Nordea study of financial targets found that only three of the OMX Nordic 40 publish any explicit working capital management target, and only one publishes working capital guidance.
The four elements of a working capital strategy
To get your working capital management in shape, you need four things:
- Clear scope
- Strong, executive ownership
- A defined strategic purpose
- Clear, communicated targets
1. Clear scope
Many businesses lack a complete view of what working capital means in their organisation, and all the factors that affect it. This means that their efforts are limited to tactical process change at particular points throughout the cash conversion cycle.
Optimising order-to-cash and purchase-to-pay processes, and inventory, are indeed very important. Negotiating new payment terms with a single key supplier, for example, can make a noticeable difference on its own. Add up the effect of hundreds of individual changes to processes, policies and technologies and you can see big results.
But there are many other ways to improve working capital management. You can tackle the effect that exchange rates or commodity prices have on the value of your cash or inventory around the world. You can find ways to reduce the total cost of borrowing, either through more efficient instruments or by pooling accounts. You can improve the accuracy of your forecasting by adopting a more transparent account structure. But understanding all of these possible approaches is only the first step.
2. Strong, executive ownership
Ownership of all of the different working capital activities is often distributed across different organisational functions. For example, procurement will manage elements of payables, such as supplier payment terms; inventory will mostly be the responsibility of operations/supply chain; aspects of receivables, such as customer payment terms, are in the hands of sales. For their part, your CFO and treasury will own funding and financial volatility metrics. But even the CFO may not have full control over the inputs and outputs end-to-end. And ownership and visibility may be further muddied by decentralised organisational structures, differences in local regulation and business customs, as well as the fact that your organisation’s carefully orchestrated processes may routinely be disrupted by M&A activities.
Only with clear and complete shared ownership of working capital management, at the highest levels of the company, can you orchestrate the full range of activities available to you to maximise results. Without this ownership, it is challenging to make broader cultural changes to how working capital is managed, or to enforce compliance with processes and policies. It is also impossible to define a clear scope or strategic purpose for working capital management.
Only with clear and complete shared ownership of working capital management, at the highest levels of the company, can you orchestrate the full range of activities available to you to maximise results.
3. A defined strategic purpose
And a strategic purpose is absolutely essential. Working capital management is a balancing act: there’s no one right answer, and one size does not fit all. Many of the factors are interrelated, and efforts to optimise one aspect of working capital may have unintended effects that undermine your strategic agenda. These need to be thought through in advance of making any changes, in order to ensure that the right actions get taken, in a sustainable way.
You and your team must consider the often-diverging needs of shareholders and customers. For instance, minimising capital tied up in inventory can improve return on capital employed and make your numbers more attractive to the market and to ratings agencies. But that does not mean it is the right thing to do: inventory can often be part of the competitive edge of the business model, and can generate EBIT.
Different organisations also have different needs of their working capital. You may have to consider the costs of funding for the working capital you need for your individual operations, or for M&A plans. You may need to consider their ability to convert capital to cash when needed depending on upcoming initiatives. And you will need to consider the impact of risk and volatility that you face. Working capital management is about understanding the risks and benefits that come with all the different options available.
4. Clear, communicated targets
There are well-understood metrics associated with working capital management, which are easy to compare year on year and from company to company. You can find up-to-date benchmarks in any number of annual surveys from the big accounting firms.
But optimising working capital is much more subtle than simply driving down the days sales outstanding (DSO), days payables outstanding (DPO) and days inventory outstanding (DIO) figures to meet an arbitrary benchmark, and that is why making comparisons, even against organisations in your own industry and region, is potentially dangerous. That does not mean you should not measure. Benchmarking is important, but you have to bear in mind the detail behind the numbers.
With quantified measurements in place, you can set and publicise clear targets right across the organisation and all its subsidiaries. Targets motivate managers across the business to move in the right direction, and they enable you to track performance against these targets at each level of the business - from specific business unit or country level up to corporate-wide goals - so you can correct any problems early, and identify the top performers to inspire best practices across the rest of the business. But these targets need to be set based on the strategic purpose you have defined - and they need to be achievable.
Optimising working capital is much more subtle than simply driving down the DSO, DPO and DIO figures to meet an arbitrary benchmark.
Get an independent perspective
Every organisation’s working capital practices and ambitions are different. When we work with customers like you on a working capital project, our specialists spend time getting to know your current approach and future needs, and then recommend specific short- and long-term changes that you can make as part of a wider initiative. We offer this service as part of our commitment to building a long-term partnership with you. So if you would like to find out more, please contact your cash management adviser.