Where is the Greatest Potential for Improving Working Capital?
Ernst & Young, in co-operation with Danske Bank, carried out a working capital management survey in June 2008. The target group was those responsible for finance and treasury in Denmark’s 500 largest companies. Our previous article on gtnews, Working Capital Optimisation Needs Management Mandate, outlined the results of the survey around benchmarking and where responsibility for working capital management is allocated within organisations. In this article, we consider where companies believe the greatest potential for improving working capital is and how they can achieve their goals.
When asked where they think the greatest potential for improvement lies with respect to working capital management, 43% of the survey’s corporate respondents said that it was in re-designing and optimising internal processes, 18% said optimising stock, an equal proportion (14% each) said optimising customer conditions and supplier conditions and 11% said compliance with existing internal processes.
The fact that 43% identified internal processes as the greatest potential for improving working capital is a positive statistic. This shows there is considerable potential for optimisation if realisation is in a company’s own hands and does not depend on negotiation with external parties. For instance, in many situations it will be easier for a company to optimise its internal processes rather than improve external payment conditions that are determined by both the negotiating position with counterparties and local customs. Optimising internal processes first will also ensure that you continue to maintain efficient business operations and that the terms remain consistent with what your customers and suppliers expect.
It is significant that 11% of the respondents said compliance with existing internal processes represented the highest potential for improvement. Senior management must not only ensure that business processes are relevant and structured; they must also ensure that those processes are actually adhered to within the company. A good example is the policy of sending out an invoice as soon as you deliver goods – this is a process that is often stipulated but less often followed in practice. In our previous article, we made the point that senior management must take a lead in establishing the company’s action plan to achieve working capital optimisation and ensure that all departments understand their role and impact when it comes to overall working capital. Measurement and remuneration can be effective tools to achieve this.
In the rest of this article, we consider more specifically the central processes that companies will need to focus on in terms of working capital improvement, such as how they work with debtors, creditors and stock.
Thirty-eight per cent of the respondents replied that their standard terms of payment are 31-60 days (invoice date to due date). This corresponds to the responses for estimated days of sales outstanding (DSO), where approximately half of the respondents (52%) replied that they estimate their DSO at between 31 and 60 days, except that one would expect DSO to actually exceed the standard terms of payment because of overdue debtors.
The distribution of responses shows that approximately one-third (27%) of the participating companies do not use automatic reconciliation. The percentages of the companies’ payments that can be reconciled automatically in the bookkeeping system also differ widely. As a result, we conclude that there are potential improvements in this area. The participating companies are aware of this, as 85% of them believe that the scope of automatic reconciliation of customer payments can be increased.
This is certainly an area that companies should endeavour to be proactive in by using analytic tools to ascertain the characteristics of customers and their reliability and punctuality when it comes to payment. The collections process can be significantly accelerated through the use of analysis and systems that automate payment reminders, for instance, or notify you immediately if a payment has not been received.
With regard to how long it takes from delivery of the goods/service until invoicing, one-third of the survey respondents replied that invoicing takes place on the same day, 42% said within one week, and 19% replied that it takes more than seven days. If we look at the number of invoices that the companies send out annually, we see that companies with many invoices are generally not faster at sending them out. These companies should have the greatest interest in standardising this process, thereby reducing service times. Apart from the potential for optimising working capital, they are also likely to realise cost savings by improving the process.
Thirty-eight per cent of the companies state that 2-10% of the invoices require individual handling due to errors in either the invoice or the basis for the invoice. This seems to be a high number and, coupled with the fact that 29% of the companies said that they did not know what this figure was, indicates a limited focus on this area among corporates. This is reinforced by the fact that 57% of the respondents believe that the error percentage can be reduced.
There is a clear connection between the figures above. The majority of those that responded either 6-10% or ‘not known’ regarding the number requiring individual handling believe that it can be improved (89% and 79%, respectively), whereas only 19% of those who replied 0-1% believe the same. There does not appear to be any correlation between the number of invoices that require individual handling and the annual number of invoices, however. This is noteworthy, as the companies with the largest number of invoices would benefit the most from a lower percentage of invoices that need individual handling.
For instance, the average error percentage among the respondents is 3.3%. The average annual number of invoices among the respondents is 984,000. Consequently, the participating companies handle an average of approximately 134 invoices individually owing to error per working day.
Overall, when we consider invoicing, it is important that corporates put in place integrated systems that feed through information about payments quickly if there is a delay and immediate notification alerts so that companies can quickly chase outstanding payments.
With regard to the companies’ reminder procedures, 10% said that they start reminder procedures one to two days after the due date, 39% answered three to seven days after due date, while 35% said eight to 20 days after due date. When asked about the percentage of the total incoming payments that are not received until one or more reminders have been sent, 30% responded 0 or 1%, 39% responded 2-5%, while 28% answered 6% or above.
The responses to these two questions do not indicate that companies with a large proportion of customers that do not pay until they have received one or more reminders generally start their reminder procedure earlier. This is significant, as these companies would benefit the most from a fast and effective reminder procedure. In order to reduce the number of late payments, it is important to analyse thoroughly the reason for sending out reminders. In many cases, late payments may be due to ineffective internal processes. A late payment may be due to an error in the invoice or an error in delivery, for instance. If a company improves these processes, it will not only save time spent handling errors, but also achieve a positive liquidity effect in the form of more prompt payments.
As the figure below shows, all three tools and methods mentioned in the question about order handling are used today by 50-60% of the participating companies. The results also indicate there are unlikely to be substantial changes to this over the next three years.
With regard to reminder and debt collection, we see that, in the course of the next three years, companies expect to be more proactive in contacting customers about payment due dates and to differentiate their approach to reminder tools. In addition, it is worth noting that the remuneration of sellers is expected to be more closely linked to incoming payments. Despite this increase, the level is still low. We also see that less than half of the companies today work with a debt collection company and they are unlikely to change this over the next three years.
Debtor policies show that, in the course of the next three years, companies expect to actively seek to improve their terms of payment in their own favour. The companies expect outsourcing of invoices and/or collection to double over the next three years from a low level. The companies also expect the use of paper invoices to fall dramatically. The survey results indicate that the companies expect only a minor increase in the use of automatic debtor reconciliation although 85% responded that the proportion of automatic reconciliations may be increased and as many as 27% responded that they never use it today.
Invoicing and Receivables
– Improvement Levers
Half of the companies surveyed responded that their creditor invoices are approved for payment within three to seven days and 40% responded that creditor invoices are approved for payment within eight to 20 days. Moreover, 87% think that this figure can be improved. Consequently, there is a relatively large spread in the number of days. If we compare the answers to these two questions, we see the majority (83%) of the companies that answered with three to seven days still believe that this can be improved. In our opinion, the respondents are therefore rather ambitious on this point.
Fifty-three per cent of the respondents replied that standard terms of payment for purchasing agreements are 31 to 60 days (invoice date to due date). This corresponds with the replies for estimated days of payables outstanding (DPO) where approximately 60% replied that they estimate their DPO to be between 31 to 60 days. Here, we see that there is generally good correlation between the number of DPO days and the standard terms of payment from suppliers.
When asked which date is used as the payment date, nearly half (47%) use ‘due date according to the invoice’, around one third (32%) replied ‘contractual terms of payment (regardless of the due date on the invoice)’ and 6% replied ‘standard creditor terms, according to the bookkeeping system regardless of contractual terms’.
If the payment date is not based on contractual terms, there is a risk of making early payments. Our experience shows that many companies do not fully exploit the credit time they have actually agreed with their suppliers. Early payment is due to anything from incorrect encoding of the agreed payment conditions in the company’s bookkeeping system to ‘convenience’ in the finance department because it fits with the periodical payment run. It is thus possible to free liquidity by exploiting the agreed credit time fully – without the need for renegotiation with the company’s creditors.
The figure below shows that approximately one-third pay their supplier invoices after the due date. This corresponds to the general development and increased use of grace days.
From the survey responses, we see that a high percentage (67%) of the companies believe that they can improve the terms of payment, both now and in three years’ time. In contrast, the percentage of respondents that work actively with this will increase from 61% today to 72% in three years’ time. Our experience shows that it is important for terms of payment to be included in the overall negotiations with suppliers and not as a separate element, as the terms of payment must be considered together with prices and other conditions.
We also see a clear development in the percentage of companies where the responsibility for DPO lies with the purchasing function. While this applies today to around one-third of the companies, more than half of them expect this to be the case in three years’ time. We also see that while 40% responded that they work actively with cash discounts today, more than 50% expect to do so in three years’ time. The use of cash discounts presumes an effective handling of supplier invoices, which, as mentioned, is an area that the majority of participating companies would like to improve.
With respect to the processing of supplier invoices, much more attention will be paid during the next three years to the use of e-invoicing, electronic approval of invoices to be paid and electronic checking of invoices in relation to orders and stock. With regard to payment processing, companies enter future payments into their bank’s payment system more than twice as often as they use direct debit services. The companies expect a little progress in both areas within the next three years; however, the future level of entering payments into their bank’s system seems low. This may be because the companies’ bookkeeping systems will be able to process future payments automatically.
It is also vital that creditor processes are securely anchored with the procurement function not the finance department in order to take the necessary action and negotiate terms with suppliers. This will certainly help to improve the overview of the entire process and ensure that the correct policies are adhered to as well as the implementation of electronic workflow and payment systems.
The responses in the figure below concerning the development of purchasing processes show that there seems to be focus on ensuring that future purchases are made from approved suppliers.
Procurement and Payables – Improvement Levers
The survey results reveal that companies have very different stock processes. The time that passes from the ordering of goods until they are in the warehouse, and from the receipt of a sales order to delivery of the goods varies considerably. Despite these large differences, there is general agreement among the companies that there is room for improvement in these areas. Seventy-three per cent and 67% responded that the two processes could be improved. It is also important that companies have clearly defined procedures and policies in place for when they need to replace stock.
The figure below illustrates that the survey respondents expect to pay more attention to all the named stock processes in the next three years. An increase in fixed procedures for reducing the stock-keeping unit in the production line indicates focus on ensuring, through the amount of capital tied up in stock, the right level of service, both internally in relation to production and externally in relation to customers.
Experience shows that not all companies work systematically with processes to remove unmarketable goods from stock. The survey results reveal that approximately 50% of the companies today work systematically with unmarketable goods. Unmarketable goods are often seen to affect the physical stock situation and may lead to appraisal, management and quality problems. It is, therefore, surprising that the companies do not pay more attention to this.
Inventory management – Improvement Levers
The survey results clearly show that the greatest potential for improving working capital is in re-designing and optimising internal processes. This gives companies the power to be proactive and review their central process carefully and thoroughly. What is most vital, however, is that companies take a structured approach to this task by implementing robust policies and ensuring that they are adhered to across the company with a mandate from senior management.
General Improvement Levers