The year 1546 was a bad year one for Francisco de Orellana. The Spanish explorer had completed a second unsuccessful journey up through the Amazon in search of the mythical city of El Dorado. El Dorado, as the legend told, was a magnificent city made entirely of gold. Like his first journey, where most of his crew perished, his second trek was marred by political intrigue, hardship, disease, and conflict with the indigenous population. To compound matters, de Orellana’s creditors were displeased with the financial management of his voyage and at one point during his quest he was forced to hide aboard one of his ships in order to avoid detention. Late in 1546, de Orellana is said to have died from a combination of grief and sickness. In many respects, de Orellana’s journeys were doomed from the beginning. His most reliable sources of advice consisted of a myth perpetuated by the local population about a “City of Gold.”
Many companies set out on similar quests to find gold. However, the ‘gold’ is not a precious metal but cash needlessly tied up in excess working capital. According to a recently survey by CFO magazine, the largest 1,000 European companies invest an average of $320m in net working capital. This is cash that could be used for capital investments, research and development, de-levering, or to reduce pension fund deficits. Improving working capital performance also increases a company’s competitiveness by increasing its return on invested capital (ROIC). However, generating cash through working capital improvement is often easier said than done.
Like the search for El Dorado, the path to working capital improvement is beset with a number of myths. They are not labeled as such but generally come in the form of proprietary methodologies, strategies, tool kits, and one-size-fits-all prescriptive solutions. While many of these solutions are offered with the best of intentions, they commonly lead to an expensive and disappointing conclusion. The key question for many companies is how to generate cash without embarking on an costly and perilous journey for “El Dorado”.
This article is about avoiding the most common myths of working capital improvement. While there are a number of myths about working capital improvement, the five dealt with below are among the most commonly held. These myths are particularly pernicious because there is a small element of truth to each one. Separating the truth from the fiction can be a difficult task – even for the financially savvy. While there is no guarantee of success, avoiding these myths will allow a company to increase the odds of achieving sustainable working capital improvement.
Myth 1: Working Capital Improvement is Only for Distressed Companies
It is a commonly held perception that only financially distressed companies need to focus on working capital improvement. Cash, after all, is critical to distressed companies and reducing stocks and debtors, and stretching creditors is a common tactic for increasing liquidity during difficult times. While it is true that distressed companies do have a particular motivation to improve liquidity, it is a mistake to believe that only distressed companies have an interested in improving working capital.
Companies across the financial health spectrum have an interest in improving working capital performance. Financially stable companies can use working capital improvement to decrease borrowings, fund capital investments and improve returns on capital. Better working capital performance is particularly relevant for companies that measure overall financial performance with measures such as EVA or economic profit. Lowering working capital reduces a company’s capital charge and increases overall returns on invested capital.
Working capital improvement can also lead to better operational cost performance. Recently an Australian food manufacturer conducted an analysis of its true cost of carrying inventory. The study included the typical charge for the cost of capital, but also included items such as obsolescence, damage, and variable handling costs. Including these incremental costs in the cost of carry equation presented a striking result. While the company’s cost of capital was 9 per cent, its true cost of carrying inventory was closer to 20 per cent! By eliminating excess stock, the company not only realized increased cash flow, but also lowered operating costs.
Myth 2: The Treasury Function Should Drive Working Capital Improvement Initiatives
Some working capital improvement programs start and end with the treasury function. It seems somehow intuitive that the treasury function should drive working capital improvement. After all, most treasury operations are responsible for cash management, and working capital improvement is all about enhancing cash flow. Involving the treasury function in a working capital improvement project helps; however, focusing on the treasury function as the main driver of better working capital performance limits the effectiveness of the project.
Working capital improvement starts in the heart of a company’s operations. It is less about managing cash flows than it is about addressing the processes and policies that drive those cash flows. For example, a large UK company recently embarked upon an initiative to improve its debtor collections. However, due to the sensitivity of certain customer relationships, the company did not want to change the terms and conditions of its customer contracts.
By mapping the processes involved in the debtor collection process, the company identified an unusually long delay in receiving proofs-of-delivery (PODs) from certain customers. This was an important piece of information since the POD was the key piece of documentation that allowed the company to issue an invoice and eventually collect payment. Further investigation revealed that some PODs were being returned via post, which added one to three days to the return interval. While one to three days might not sound significant, for this company a delay of a single day resulted in a missed opportunity to bill approximately £2.5m of sales. By migrating to the electronic delivery of PODs, the company reduced the amount of time it took to return PODs and thus increased the periodic amount invoiced and collected. By addressing underlying operating issues in logistics and distribution (not treasury), the company made a meaningful impact on debtor collections.
Myth 3: Improving Working Capital Requires Significant Investments in Systems and IT
Some companies believe that improving working capital performance requires the installation of complex enterprise resource planning (ERP), due, in part to the persuasive claims made by ERP software vendors regarding the ability of their systems to remedy a variety of operational and financial problems. One popular software provider advertises that its system can “streamline your supply chain, bring products to market faster, get more out of procurement, and eliminate duplication of effort.” Certainly, putting the right information in the right hands at the right time is an essential component of working capital improvement. In many cases, improvements in cash flow will follow directly from improvements in information flows. However, large investments in ERP systems and costly IT overhauls are not necessary in order to generate results.
The real danger in relying strictly on IT transformations is that companies delay the opportunity to improve working capital performance until the ‘right’ systems are in place. Some ERP systems can take several years to implement and the implementation process can cause significant disruption to the business. Achieving meaningful working capital improvements without relying extensively on IT systems requires probing interviews, simple debtor listings, contract reviews, and basic process mapping to diagnose improvement opportunities. Less complex systems improvements such as the installation of a data warehouse and a business intelligence system can substantially improve access to working capital information, but do not involve the cost or the implementation burden of many ERP systems.
Myth 4: Working Capital Improvement Needs to be a Large Corporate Initiative
Companies commonly think of working capital improvement as a broad corporate initiative. In most cases, the impetus for better working capital management comes from the senior leadership of a company, and in some companies corporate-wide initiatives can be effective. However, companies should not be deterred from pursuing improvement opportunities because of the perceived need for a large, complex corporate program. Meaningful results can be obtained with a focused effort on a few key areas of the business.
The key to any working capital improvement program is to focus efforts where they will have the most impact. One way to focus efforts is to uses the 80/20 rule to identify business units or product lines that represent the lion’s share of the working capital. A multinational food company recently undertook a stock reduction initiative. The company had over 30 business units that spanned the globe from North America to New Zealand. The coordination effort of implementing a corporate stock reduction opportunity across this many business units around the world would have been challenging to say the least. However, a simple ranking of what units held stock revealed that over 50 per cent of the company stock could be addressed by focusing on four business units. The company developed detailed stock reduction plans for these four business units and shared the techniques with the remaining business units. By focusing resources where it mattered, the company made an impact on overall stock levels without developing and implementing a slow and complex corporate-wide initiative.
Myth 5: Working Capital Improvement is About Generating Short-Term Results
While it is important to seize short-term opportunities to generate cash from better working capital management, it is a mistake to assume that working capital improvement is only about short-term results. A short-term focus may be useful for increasing liquidity, but without a long-term commitment to better working capital management, companies will often see these gains erode over time.
Sustainable working capital improvement requires constant vigilance. Companies that are successful in making improvements last do so because they make substantive changes to their underlying business processes, performance measurement programs, and incentive schemes. Working capital becomes an important measure of business performance alongside revenue growth and margin enhancement. Institutionalizing better working capital performance is a good way to ensures lasting improvement and to inculcate the ‘cash culture’ that many companies aspire to but few achieve.
Conclusion
It is interesting to wonder what would have happened if Francisco de Orellana had not believed in the myth of El Dorado. Perhaps, the year 1546 would have turned out much better than it did. Avoiding some of the myths about working capital is a good first step to starting a successful working capital improvement initiative. Leadership, perseverance, a practical focus, and luck is awinning strategy for mining the balance sheet for cash and making lasting improvements to working capital performance.