Why are accountants reluctant to make the hard calls regarding reducing working capital and thereby improving cash flow?
Working Capital, current assets less current liabilities, is now number two in the list of top internal concerns for CFOs in Europe, the US and in Asia whilst forecasting cash flow is number one according to the May 2009 Business Outlook survey by CFO Europe.
Why has the Cinderella area of accounting, namely working capital, now become such a hot topic? The reason lies in several key factors namely radical decrease in bank financing, rising borrowing costs and a marked reluctance on the part of insurers to cover clients with 'sufficient' limits of cover as well as the tightening by accounting bodies like the Audit Practices Board in their views on 'going concern' and by the Financial Reporting Council on the reporting of the company's cash flow requirements and the need to discuss liquidity with the auditors.
Accountants are therefore faced with pressure from internal strategies that suggest cost reduction is required immediately as well as attempting to meet external demands for greater transparency regarding areas of cash flow. Working capital is at the heart of all these issues and yet making the decision to reduce working capital is fraught with issues.
Mistake 1 - Managing the Income Statement and NOT the Balance sheet
In a downturn revenues and profits will become squeezed by many drivers re market, pricing etc however if employees focus on this as well as press releases they will become deflated, demotivated and generate a culture of negativity.
By incentivising the work force to review areas of the balance sheet that they can directly impact i.e. receivables, inventory and creditors then internal cash could deliver cost savings, savings in interest charges and enhance the quality of the Balance Sheet.
Mistake 2 - Rewarding the Sales team for Growth alone
If you reward sales and service teams for improvements in Net Profit (after all overhead and interest penalty costs) of individual contracts and customers, rather than on growing revenue targets, you will drive out poor contracts and unprofitable customers. However you may lose major revenue streams that may be seen by the markets as a sign of not being competitive and will therefore mark down your share price accordingly.
Mistake 3 - Over-emphasising quality in production
Customers will not appreciate incremental improvements in quality in recessionary times as it will need to be costed into the price of the product or service and if the manufacturing/service cycle is too long customers will postpone or even curtail purchasing anything, therefore increasing Work in Progress.
So how do accountants deal with these issues? Again they are faced by various 'old hat' methods that have pitfalls too:
- Believing that working capital management problems can be fixed solely by the finance department - since the levers that most directly impact working capital are operational in nature, working capital optimisation programmes must extend beyond the finance department and engage the company's entire managerial team.
- Engaging in artificial efforts, such as delaying payments to suppliers or indiscriminately stepping up collection activities, to boost quarter-end or year-end performance metrics - In business, as in physics, every action is met with an opposite reaction. Delaying payments to vendors may reduce working capital over the short term, but that improvement is likely to disappear over time as vendors adjust their pricing accordingly. A haphazard, ill-managed collection push is unlikely to achieve any long-term results, and may alienate customers.
- Beating the 'cash is king' drum internally and to the City, but not linking executive compensation to cash flow and comprehensive working capital metrics - for most managers, compensation drives behaviour better than a mantra.
- Waiting for a business recovery before trying to improve working capital processes - just as growth should not be used as an excuse to ignore working capital, neither should a crisis. Doing so can significantly inhibit a company's ability to grow and meet demand once business rebounds.
- Believing that enterprise resource planning(ERP) systems and technologies are the silver bullet for working capital improvement - many large investments in ERP systems generally do not, by themselves, bring working capital improvements. Over the near-term, they can cause deterioration in working capital performance as key managers and employees are distracted from their daily routines and forced to fine-tune the new system.
- Failing to connect suppliers and customers across the enterprise to gain significant, mutually rewarding benefit - a company can improve working capital performance while treating itself, customers and suppliers as three distinct entities, but maximum benefits are achieved when business processes mirror the inextricable ties between the three entities.
- Delaying payments to suppliers as a tactic to increase cash flow before fully exploring how your company can negotiate better terms or gain discounts for prompt payments - once you become a late payer, your bargaining position is severely compromised. Instead, use your leverage as a prompt-paying customer to your advantage. You'll not only save more money, but retain the good will of your suppliers.
- Reducing inventories without improving the overall supply chain process -there is a direct correlation between inventory management methods and the level of customer service the company can provide. If you simply reduce inventory levels without addressing core processes customer service will suffer.
- Letting debt become overdue before identifying disputes and contacting customers to resolve them - A better practice is to contact your most valuable customers before payments are due to resolve any potential disputes. For payments that do become delinquent develop a proactive, systems-based, event-driven procedure to resolve disputes. Assign collection responsibilities to specific individuals and escalate that responsibility to increasingly senior employees as invoices become further past due.
- Having a business model geared around making-to-stock when you have the capability of making-to-order or making-to-demand - 'If you build it (they) will come' is a movie cliché (Field of Dreams), not a sound business practice for most companies. Gearing your business model to customer demand is simply more efficient and logical than gearing it to sales projections. At companies that must rely on sales projections, develop forecasting techniques that incorporate intelligence from all relevant segments including not just sales but manufacturing, distribution and marketing.
John Mardle, Working Capital Practice of Develin and Partners. John Mardle will present a CPD course on 'Driving Capital and Ensuring Efficiency through Working Capital Optimisation' for the ICAI on 8th June 2009.