Managing working capital can be a difficult thing to do, so it is important to understand some characteristics that you can take advantage of to ensure that your organisation is fully effective at improving working capital. The following points will feel counter-intuitive, but they are all true and are seen time and time again in different countries and industries. These issues are known by working capital management experts, but rarely shared with the uninitiated.
So let’s take each of the 5 secrets one by one.
SECRET NO 1: “THE TIME VALUE OF MONEY”
Expressed very simply, the time value of money is the amount that you would have earned from that cash, if it was not locked up in working capital.
So if my customer wants a 60 day credit term, then what would I have earned with that cash, if I had not offered the credit term. The problem with this is that most sales and procurement people engaged in the transaction between the selling and buying organisations will have very different views on the actual value of this credit term:
- It may be that both sides place no value on the credit term since it is not part of their bonus regimes.
- It may also be that they do value the credit term but at completely different rates.
So if the cost of money for the selling organisation is less than the cost of money for the buying organisation, it will be more likely that the seller will offer extended terms to the buyer. In this case, the buyer will also be delighted since they place a higher value on reducing working capital.
These differences between organisations can be very large:
- For example one very cash rich company could have a cost of capital of 4% since that is the deposit rate that they can earn with their bank.
- Another organisation could have a cost of capital of 18% since that is the rate of interest that is paid on the company overdraft. Clearly these organisations will have very different views on whether they are sensitive to holding working capital or not.
SECRET NO 2: “THE DISCONNECTED ORGANISATION”
We often assume that organisations, particularly large organisations, move in lock-step. Occasionally this is true, but more often than not this is a myth.
Recently at an FMCG client one of their major customers had renegotiated their agreement to include a 90 day payment term. The negotiations had been very tense and eventually they had given in to the customer. More than 18 months later we discovered that the same customer was paying our client in 12 days! So their procurement people had successfully struck a very hard bargain, but clearly never told their own accounts payable department.
This is much more common than most people believe. A standard check is to compare the contracts that procurement have agreed with suppliers and compare those terms to what is in master data: there are always differences. The same is also true on the sales side. The effect of this is that your reported overdue receivables will be lower than you think since many customers believe that their payment term are longer than those stated in their contract.
SECRET NO 3: “LOTS OF CUSTOMERS PAY EARLY”
Most companies have the strong perception that customers might pay on time but often pay late. In fact there are a potentially large proportion of customers who also pay early.
But most measurement of collection performance only operates at the aggregate level, blending all these different behaviors together.
For example at one client we were asked to do an analysis of their collection performance. The Day Sales Outstanding was 34 days and the best possible (if everything was paid on time) was 35 days.
The client was absolutely insistent that we look at this business even though it looked like an excellent performer. It turned out that the client was right to be persistent. When we segmented the customer base based on payment behavior, we found that almost one third of customers paid early on a regular basis. This masked the fact that another one third of customers paid late – sometimes very late. Although this business looked like a top performer, there was a huge opportunity to improve that had not been obvious before that point.
SECRETS NO 4: “SUPPLIERS INVOICING PROCESSES CAN BE VERY POOR”
If the supplier hasn’t sent you their invoice, you can’t pay it. That may seem obvious, but it is remarkable how many times this actually happens. One reason can be that an invoice was sent to the wrong address but a more common reason is that the invoice has not been sent.
At one client a supplier sent all their invoices in a box on the 28th of each month. This caused a big problem for accounts payable since there would then be a big rush to get all the invoices registered before month end.
When we asked the supplier why they did not send the invoices at a greater frequency their answer was that it saved on postage cost! When we asked them to change the practice the supplier said they could not since it would mean changing all customer billing at their end.
When we have been able to do the analysis some of the statistics are quite breath-taking.
The average time between the supplier invoice date and the date the invoice is received in your accounts payable department is between 11 and 13 days. More than 75% of all invoices sent by post take more than 7 days to get to accounts payable. And that has nothing to do with the postal service in the majority of developed economies.
From an efficiency perspective the simple solution is to move to some form of electronic invoicing. But from a cash flow perspective, it’s a simple incentive to change the way invoice due dates are calculated in accounts payable. If the count starts from the date that accounts payable receives the invoice, then this will encourage the supplier to change their billing practices.
In reality more than 90% of suppliers do not change their billing practices after being notified of this important change. Then the other positive result is addition sustained cash flow being generated through slightly later payment of supplier invoices.
SECRETS NO 5: “MOST COMPANIES DO NOT FULLY UNDERSTAND CUSTOMER DEMAND”
Best practice says that a company should use statistical methods to understand their levels of stock holdings compared to customer demand. Others ignore the statistics and go on “gut feel”. If you are in the latter group, it is very likely that you have too much inventory since the human brain tends to over compensate against adversity. But even those that do use statistical methods get it wrong.
For example, calculating safety stock is a fairly straight-forward calculation, but it is important to understand the level of customer service required. Statistically speaking trying to deliver to a 100% service level is impossible, as it would require holding an infinite amount of inventory.
For example, if the customer service level is reduced from 98.5% to 95%, without changing any other stock parameters, the level of inventory can be reduced by 32%.
So it is vitally important that some asks the customer what is expected. Many sales people shy away from this in the same way as they often do not include the customer in the demand forecast.
The result is that sales forecasts will be wrong at the detailed item level and place a lot of pressure on manufacturing to deliver enough products to fulfil the aggregate revenue forecast.
This was originally published in Working Capital Channel blog.