Cash & Liquidity ManagementCash ManagementPracticeWorking Capital Management from a CFO’s Perspective

Working Capital Management from a CFO's Perspective

The role of the CFO and the finance department as a whole has changed dramatically in recent years. Changes in regulations and corporate governance, the move towards centralisation and technological advancements are just some of the many factors that have a continuous effect. After a phase of getting to grips with changes in regulation and corporate governance (e.g. IFRS, Sarbanes Oxley, Basel II), there will be a need to increase the focus again on (shareholder) value creation. This article argues that one element where value creation can often be achieved is in the field of working capital optimization. By first analysing the business through financial ratio and cash flow analysis, and in a later stage using the right incentive scheme to implement changes in the working capital management strategy and related processes, a CFO can achieve a considerable increase in value creation for the company.

According to a survey1 among leading North American and European companies, some finance executives say outright that finance is no longer a staff function at their companies. Others make it clear that finance is not merely a business service, but rather an embedded competence of operating businesses. Gone are the days when corporate finance groups focused primarily on tabulating, auditing and reporting financial results. Increasingly, as the results of this survey indicate, at some of the best performing companies, the finance function drives strategy execution through instilling metrics and an analytical mindset that makes thinking about value creation a central part of all managers’ jobs. At GE, FedEx, Costco, Intel, Pepsi, and other companies, finance executives say that finance is never less than a close partner with operations – and often much more. Finance executives interviewed for this survey say that finance serves to equip and to educate line management on the value created by their day-to-day decisions.

Of course, among the most challenging company wide change initiatives of recent years has been companies’ compliance with Sarbanes-Oxley Section 404. Many corporates have incurred significant costs while becoming compliant. What does come as a surprise though, is the extent to which financial executives (especially from the US, where the introduction was earlier) have managed to find, in this legislative burden, yet another way to drive shareholder value. A spokesperson for GE observes, “We have been a proponent of Sarbanes-Oxley (SOX) because it creates a certain amount of thoroughness which is the right thing to do. It is obviously beneficial and necessary for compliance, but it also allows you really to audit your business, your operations and your systems in a different way. Our goal has been that anytime we do a process like SOX to ask: What’s the value we can extract from that process?.” In Europe, where most companies have had to comply with SOX as of 2006, and are still struggling with the whole compliance framework, this approach is most likely still to set in.

Organisations are momentarily clearly in a control phase. Nevertheless, when corporations get accustomed to SOX compliance – and to name another, the new IFRS accounting rules – there will be time again for more focus on value creation. In embarking on value creation, in a function where diversity and increasing complexity is at hand, a CFO needs to work in a structured matter. A CFO management framework could facilitate an effective finance organization and drive to finance transformation.2

Figure 1: CFO Management Framework

As shown in the CFO management framework (Figure 1), capital optimization is one of the eight core disciplines and attributes critical to an effective finance organization. The focus in this article is on the working capital strategy. In order to develop and maintain an optimal working capital strategy, one first has to have a profound grasp of the business (know the main value drivers).

In addition, the physical and financial value chain (Figure 2) constitutes an analysis framework and shows instruments that the CFO has at his or her disposal. From a company’s viewpoint, its operations can be regarded as a continuous set of working capital cycles, which may reinforce or attenuate one another. Optimally, the moments in the physical value chain where cash is needed are matched with moments in the financial value chain where cash is in access. By matching these moments, less cash will have to be kept on balance, or less extra credit will have to be taken on.

The central question in a working capital management project is how to (re-) balance the physical and financial value chain in such a way that an optimal contribution to shareholder value is realized.

The first step is to establish the way in which the general goal of adding to shareholder value has been translated into measurable (financial) goals. In most cases, this will result in a set of financial performance indicators, which not only govern the central financial management focus, but also tend to define the ways subsidiaries are controlled. Performance indicators that spring to mind are return on equity (ROE), economic value add (EVA), return on investment (ROI), return on net assets (RONA) and similar concepts.

The key is then to identify the main value drivers and the way that they affect the relevant financial performance indicators. A way to detect the main drivers is to perform a business analysis. There are several ways to go about doing this. It is interesting to analyze the interaction between physical value ratios and financial value ratios. We will go into this subject at a later stage. When the main drivers are clear, the CFO can formulate a strategy to streamline the key value drivers and the related processes in order to maximize value. From a financial point of view, the goal is to have on one hand sufficient cash available to settle current financial obligations and on the other hand minimize the cost of keeping excess cash available. The physical value chain is however leading. The financial elements need to be structured around the physical value chain of the company.

Figure 2: The cash conversion process from a CFO’s perspective

Business Analysis

Before getting into the different variables, the CFO has to target the streamlining of business processes and optimize the working capital strategy. Let us first elaborate on the business analysis necessary to detect key value drivers. By combining a business strategy analysis and a financial analysis (ratio and cash flow), a solid picture of main drivers can be obtained. The purpose of a business strategy analysis is to identify key value drivers and business risks and to assess the company’s profit potential at a qualitative level. Business strategy analysis involves analysing a firm’s industry and its strategy to create a sustainable competitive advantage.

With this qualitative analysis, one can draw better conclusions when analysing the financial ratios and cash flows. Ratio analysis focuses on evaluating the product market performance and financial policies, while cash flow analysis focuses on liquidity and the financial flexibility of a firm.3

In the execution of a WCM project, a CFO needs to keep in mind that the division of the cycle into small processes not only poses the question of reliable measurements, but also tends to underestimate the importance of interconnectivity. In plain English, the things you charge in your purchasing process may have a significant impact on the things you would like to do in the production cycle.

The starting point for ratio analysis is for example the company’s ROE. The next step is to evaluate the three drivers of ROE – net profit margin, asset turnover and financial leverage. Net profit margin reflects a company’s operating management, asset turnover reflects its investment management and financial leverage reflects its liability management. In this case, we are primarily interested in the short-term asset turnover and the working capital aspects of investment management.

Figure 3: Working capital project set up

Useful ratios for the analysis of working capital management are: operating working capital to sales, operating working capital turnover, accounts receivable turnover, inventory turnover, accounts payable turnover, days’ receivables outstanding, days’ inventory, days’ payables outstanding and duration of the cash conversion cycle. The key is to examine to what extent physical ratios are reflected in the financial ratios. Examples of physical ratios are: days in inventory, days of payables outstanding, days in production, days sales to billing and days revenue in receivables outstanding. Formulating a combined view on these two types of ratios will prove to be a challenging, but rewarding, approach.

Cash flow analysis supplements ratio analysis in examining a firm’s operating activities, investment management and financial risks. Cash flow analysis allows you to assess whether the company’s operations generate cash flow before investments in operating working capital, and how much cash is being invested in the firm’s working capital.

Benchmarking the financial ratio’s with peers can give insight in how your working capital management compares with others in the sector. Comparison, however, does not necessarily mean equations. Having a better and thus cheaper working capital management strategy might create a competitive edge.

Implementing a Working Capital Management Strategy

After the business analysis has revealed the key value drivers and the investment management, the CFO has the next difficult task on his or her hands of optimizing the two. How to choose from the various options that are available within the physical and financial value chain? Not only choosing the new strategy creates a dilemma, but also implementing it. We argued before that the key to effective implementation is the way you structure the incentives for all parties involved. In most cases, this incentive structure is already in place. The question then is whether it is proving effective, and what to do when it does not.

In most cases, there is more than one significant restrictive force in play. A CFO needs to find a good balance between the different forces within and outside the company. Furthermore, they have to optimize the combination of key drivers in the physical and financial value chain so that investment management and shareholder value are satisfied in a favourable manner. Finally, he has to constantly balance the relative costs of implementation and the expected benefits in terms of the financial performance indicators on the one hand and the less measurable effects on client and supplier relations and organisational structure and culture on the other hand. These three tasks are also interrelated.

When we go into the different variables of the financial value chain, these can be divided into separate working capital cycles: the purchase-to-pay, the production and stock and the order-to-collect cycle (the combination of the three is called the cash conversion cycle). Each cycle has its own restrictive forces and its own implementation solutions.

Taking the purchase-to-pay cycle as an example, lengthening the purchase-to-pay period often means paying extra (lower rebates, or higher credit interest). By centralizing the purchasing, accounts payable and receivable function, you can create size of scale and in this way get more bargaining power. In that strategy you will need to set up incentives for subsidiaries in such a way that they are compensated for giving up authority and are convinced that they are better off by pursuing the central view on payments and collections management. An illustration of setting up incentives for subsidiaries is to let performance measurement be dependent not only on revenue return, for instance, but also on working capital ratios that were mentioned earlier. This way, subsidiaries will be more prone to co-operate pro-actively.

The production and stock cycle poses other problems. Obvious goals are to shorten the production process, reduce stocks of raw materials and intermediate products and reduce stocks of final products. In all cases, numerous issues arise: do we have enough stock to keep our production at the same level as demand, does a shortening of the production cycle pose any threats to quality standards and safety issues, are we able to adjust easily to fluctuations in demand? In the order-to-collect cycle, an example may be e-billing. It is clear that the bill presentment via the Internet will shorten the order to collect cycle. It does however also pre-suppose that clients co-operate in such a billing process. This is clearly not always the case.


We started by saying that the role of the CFO and the finance department as a whole has changed dramatically in recent years. Organisations are momentarily in a control phase and the CFO is in the centre of the control process. Nevertheless, when corporations get accustomed to recent changes in regulations and corporate governance, there will be time again for more focus on value creation.

Key Action Points

  1. WCM projects will have better results when the analysis focuses on the financial performance indicators, both on a group level and on an affiliate level. This may or may not be the same kind of indicator.
  2. WCM projects are based on a thorough understanding of the operational cycles, but need to be supplemented by a business analysis of the relationship between the key value drivers and the performance indicators.
  3. Business analysis needs to focus on the relationship between the operational duration of the different stages in the working capital cycle and different financial ratios.
  4. The result of a successful WCM project will be a set of WC enhancements that are classified, based on the relative costs of implementation, the expected benefits in terms of the financial performance indicators and the non-measurable effects on client and supplier relations.
  5. Finally, one should never lose sight of the interconnectivity elements in the different sub-cycles and their effects on performance and the consequences for the environment in which a company operates.

1 Different Paths to One Truth: Finance Brings Value Discipline to Strategy Execution, CFO Research Services in collaboration with Deloitte Consulting LLP, March 2006.
2 Deloitte Consulting’s CFO Management Framework.
3 Business Analysis & Valuation, Palepu et al, 2004.

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