Head office treasury and finance teams often find themselves in a frustrating position when it comes to managing working capital across their organisation. While they play a critical role in the provision of liquidity, they sometimes have limited ability to influence the efficiency of the working capital process they fund. Ultimately the cost of a poorly managed working capital cycle will have a constant drag on earnings and if treasury is required to fund shortfalls, external interest costs will increase.
The terms cash management and working capital management are often used interchangeably in a corporate environment. This can be slightly misleading as while they are closely related disciplines, cash is simply one aspect of working capital management. Therefore head office controllers and treasurers seeking to initiate working capital improvements will firstly need to understand the behavior of the short term assets and liabilities that drive the process – notably accounts payable, accounts receivable and inventory.
Who’s involved in the Process?
In large companies, many people will play a role in the working capital cycle. The exact makeup of stakeholders will vary depending on the company and industry but typically people in the following departments will have the largest influence:
Sales – Sales teams agree payment terms to new and existing customers. The payment terms offered by sales teams form a key part of commercial negotiations, particularly in low margin industries, and will influence future working capital.
Credit and Collections – Credit teams play a dual role in managing working capital. Firstly, they should be involved in setting acceptable credit limits and terms that can be offered by their sales teams to customers. Secondly, credit and collection teams monitor customer invoices versus credit terms and chase up overdue payments when required.
Procurement – Procurement teams have huge influence over working capital as they, for the most part, control the stock levels maintained by companies. For a manufacturing based business, with large raw material requirements, procurement will typically be the biggest spenders and control the largest budgets.
What metrics should I be monitoring?
Any improvement proposal or strategy must be backed up by facts. By gaining an understanding of the metrics that influence working capital within your organisation, you will be in a better position to positively influence the overall process. Start with the simplest metrics first and focus on the largest sections of your business or the areas that experience the most volatility.
Gaining visibility over the following metrics and understanding their variability will provide the basis for any improvement efforts:
Days Sales Outstanding (DSO) – DSO shows how long it takes to collect cash from customers. Faster sales collections have a positive working capital impact.
Days Payables Outstanding (DPO) – DPO shows how long it takes to pay suppliers. Longer payment durations have a positive impact on working capital.
Days of Inventory Outstanding (DIO) – DIO shows how quickly inventory is sold. Selling stock faster has a positive impact on working capital as it means that cash is not tied up in unsold goods.
Cash Conversion Cycle (CCC) – The CCC uses DSO, DPO and DIO to demonstrate how effective a company is at managing its short term assets and liabilities. This is a key indicator of management efficiency.
A short cash conversion cycle indicates that a company is managing their working capital cycle in an efficient manner and cash is being converted quickly from raw materials to cash sales receipts.
To make working capital improvements, finance and treasury teams must be firmly aligned with the people managing the various components of the cycle while also having a firm grasp of the performance metrics and KPI’s. Without access to, and an understanding of, the metrics that govern your working capital cycle it will be impossible to initiate positive changes.
