What are the dos and don’ts to improving your working capital?
Improving your working capital is an easy way to achieve some quick wins. But what’s the best approach and what are the pitfalls to avoid?
The vast majority of procurement organizations and professionals are focused – and incentivized – entirely by EBITDA. For those working in the function, this usually means working to reduce costs, while maintaining service levels.
But while this is an important part of the job, many procurement teams are failing to realize even bigger financial outcomes that can be achieved, fairly painlessly, by leveraging working capital improvements. While the benefits from reduced cost usually take a year or more to deliver, over the process of a contract, working capital gains can be achieved almost immediately, and with relatively little effort.
On the supplier side, the most obvious method of improving working capital is to increase payment terms, so cash remains in the business for longer. Here, the benefit can be felt almost as soon as the next run of invoices is processed because instead of paying suppliers after 30 days, you’re paying after 60, creating immediate and significant improvements to the cash situation.
The first stage for any procurement function looking to make improvements is to define a strategy, working with finance to identify what payment terms it would like to operate, and how to segment suppliers. You cannot push the same payment terms for a utility business as you can for cash-rich professional services, for instance, so thought needs to be given to how critical cash is to the business or sector.
You cannot push the same payment terms for a utility business as you can for cash-rich professional services… so thought needs to be given to how critical cash is to the business or sector.
One issue here, though, is that very few firms know what the optimum payment terms should be. Many businesses might say 45 days, but there are cases where this can be lengthened without causing too many issues for suppliers.
Sometimes suppliers are also clients of the same firm, in which case, it should be possible to compare the payment terms you operate with those of the supplier business, using information from your own receivables system. In some sectors, or for some organizations, there is also data available online that can reveal the days sales outstanding of different companies, which can, in turn, be compared with your own days payables outstanding. This can highlight cases where terms could be matched, simply by bringing your own practices into line with that of the supplier organization.
Even if the data is not public, it’s possible to look at specific categories and match the days sales outstanding from a list of peers in the same industry and compare your own payables terms to that. Mathematically benchmarking the situation removes any gut feeling from the process. This can help overcome any objections from within the business and allay fears around upsetting suppliers, as well as being able to provide a clear business case for investing the time and effort in such initiatives.
Once a policy has been established – both for the business as a whole and with particular categories and suppliers – it’s time to start implementing the new arrangements. When new suppliers are selected or contracts awarded, it’s simply a case of ensuring these are reflected in the terms and conditions, which many suppliers will be all too happy to accept in exchange for the business.
For existing suppliers, there are two different approaches. For tactical suppliers or those selling indirect goods or services, one of the most effective ways of pushing these new terms is for the CPO or CFO to contact them, informing them that terms and conditions have changed and that the changes will apply with immediate effect.
Some suppliers – often around 30% – may object and push back against the new terms. This is most likely to be larger businesses that are aware of just how important working capital is to them. In such cases, terms can be negotiated or alternative sources of supply found, depending on the importance of the item or supplier.
For more strategic suppliers – or those for which there is a legally enforceable contract in place – there may be a need to conduct one-on-one negotiations, with the aim of improving the existing situation. It’s not uncommon here for those suppliers to push back, potentially offering longer payment terms in exchange for a higher price.
Once any changes have been agreed, it’s vital that IT systems are ready for the next invoice. The last thing you want is to negotiate or push terms to a supplier and then have someone else in the program manually changing the payment terms. When we get involved in such projects, we work with IT teams to enable the system to make sure that the payment term is defined and inserted in the supplier master file, but not challengeable at invoice level.
It’s also important to ensure that those working in accounts payable are aware of the changes and understand the new terms. One example we came across recently was a care home business, which had payment terms of 30 days from the 20th of the following month, giving them a respectable average of around 45 days. Often, however, the accounts team would forget about the 30 days and pay all invoices from the previous month on the 20th. Such instances clearly negate any efforts made by procurement to improve the working capital situation, although they also create the potential for significant benefits to occur once issues have been identified and overcome, with minimal effort.
There are other levers that procurement can use to help improve the working capital position beyond payment terms. One key area is inventory, where lead time and minimum order quantities can be reviewed. Often suppliers are able to suggest more efficient ways of working, which can help optimize inventory and release cash, perhaps allowing businesses to purchase on a monthly basis rather than further in advance. Sometimes, salespeople will be more open to these kinds of discussions than they are on price reductions, as many will be incentivized by revenue rather than service levels or minimum order quantities.
Aligning procurement with supply chains
All this, however, requires procurement to work closely with its supply chain colleagues, and often the two functions are not sufficiently aligned. This can come down to simple geography; procurement can be based in a head office, whereas the supply chain function may be in, or near, a warehouse cluster, often in the middle of the country. Working closely on initiatives – including sending dual representatives to meetings – can not only improve working capital and reduce the total cost of ownership, but also lead to discussions around how to create greater efficiency in other areas, which can benefit both supplier and buyer.
Tackling the topic of working capital also means procurement needs to work closely with finance and the CFO. Ultimately, cash is a finance topic and finance should be beating the drum about this, but it’s one that is very much impacted by operations.
Procurement, though, is often reluctant to get involved. Much of the issue comes down to the fact that procurement is typically incentivized by EBITDA rather than the total cost of ownership, which would include working capital. One example is a procurement team buying six months’ worth of stock because they will get some savings benefit, without even thinking about the impact on cash. This should not be seen as only a CFO’s problem but an operational issue, managed by procurement. Organizations should look to train staff in how to maximize working capital, as well as re-evaluating the criteria on which it rewards CPOs and the procurement function.
There are other reasons for procurement to push this as an issue, beyond the potential to improve the working capital situation. When a business is short of cash, it will typically use the aggressive tactic of putting an invoice into the next payment run and delaying the payment by 30 days, usually causing significant tension with suppliers and potentially jeopardizing both deliveries and the relationship. A better solution is to renegotiate with the supplier for 30 days more and to pay on time, so the relationship is preserved.
Beware the consequences
For businesses that fail to get to grips with working capital, the consequences can be significant. A company with too little working capital may struggle to pay its bills on time and may need to delay payment. Suppliers may reduce the amount of credit they give as a result or refuse credit altogether.
If a company is forced to resort to borrowing, it will have additional interest charges to deal with, and banks may even charge higher interest rates if they think there may be a liquidity problem. Firms that fail to look after working capital could face banks looking to reclaim debts as a result of breaching their bank covenants, and, if they run out of cash to pay their bills or staff, even bankruptcy. One business even fell out of the FTSE 100 as a result of a downgrade, sparked largely by concerns around its cash position.
Firms that fail to look after working capital could face banks looking to reclaim debts as a result of breaching their bank covenants, and... even bankruptcy.
Then there are the missed opportunities, which cannot be pursued due to a lack of capital. IBM, for instance, was able to purchase Lotus in part thanks to the cash released through working capital improvement projects, but this would not have been possible without such efforts. Businesses also face being unable to buy in bulk, potentially missing out on discounts, and may even find themselves unable to take a large order as they cannot finance the additional workload. Growing through merger or acquisition is also off the cards if there is insufficient cash available.
For those businesses that prioritize this and make significant in-roads, the benefits are clear. Working capital is actually the cheapest means of accessing finance, removing or reducing the need for expensive bank finance, equity dilution or issuing shares. It can also lead to a bigger impact than classical procurement savings, which will have a more immediate effect on the business.
In some cases, it’s possible to improve the balance sheet by as much as $7.75 million, depending on the size of the business, which can prove extremely attractive to potential buyers or private equity owners.
Finally, there are the additional gains that come from having a more streamlined and harmonious organization, where procurement, supply chain and finance work together, not only on working capital and payables, but in other areas too. This leads to more efficient and congenial working relationships throughout the business and the potential for further initiatives to drive value, reduce cost and ultimately create a more sustainable and profitable organization.