Dec 03 2014
One should adopt a rigorous approach geared towards continuous improvement to achieve results that can be sustained under different economic conditions. The key area to focus on is cash management, to minimize carrying costs and maximize yield of idle cash. Other areas to monitor include the performance of accounts receivable, accounts payable and inventory management.
In this article, we have included planning steps that may be employed by companies to proactively target working capital to the lowest sustainable levels and achieve an optimal business enterprise valuation.
For one, the firm should undertake a rigorous analysis of its current working capital requirements based on internal and external factors. These internal and external factors can include the type of industry (and existing practices), the company strategy, the business model, seasonality, how the company wishes to compete in the marketplace, and money market yields, among other factors.
The answers to certain questions may be explored. Is it an asset-light or asset-heavy industry? Are products sold or are services provided? If products are sold, does the company have a strategy of 100% product fulfillment? Is competition to boost sales primarily a discounting game, or do non-price factors such as credit terms matter? What time of the year does the working capital bulge? How competitive are the money market yields at this point in time? Other factors, such as how the collection or payments system is being managed, must be reviewed.
Along with a rigorous internal analysis, one can also benchmark against peer companies. Analyzing working capital metrics of peer companies has two main advantages. Benchmarking allows a company to understand its position relative to peers within the same industry, and compare performance.
At the same time, a firm can compare the working capital effects of its business model and strategy versus that of its competitors. Apart from having visibility on the company’s position in the country where it operates, additional insight may be taken from analyzing its peers within the same region.
Another advantage of conducting a benchmarking analysis comes from observing how the best-managed peers manage their accounts receivable, accounts payable, and inventory. Benchmarking against better working capital metrics may signal opportunities to further improve working capital management. For instance, if in the process of the benchmarking analysis, a company finds that its accounts payable turnover is considerably shorter than its peer companies, this provides an opportunity to renegotiate with its suppliers for more favorable, yet competitive, payment terms. Ultimately, good working capital management leads to a shorter time to convert working capital into cash.
The cash conversion cycle (or the sum of days inventory, days receivable, less days payable) shows the number of days needed to convert sales into cash after payment of obligations. It also shows how long working capital is financed.
By targeting a faster cash cycle, the company can improve its cash flow and use its resources more efficiently. The situation is not so easy to navigate all the time. The firm has to manage competing priorities, balancing what it values versus what is important to its customers.
For instance, a firm that decides to tighten collections may risk alienating customers who may wish more liberal payment terms. More liberal payment terms, however, result in a longer cash cycle and a higher opportunity cost of funds for the firm. Maybe the firm can also offer discounts for prompt payment. However, the discounts should not be so large as to eat into product margins.
For inventory management, keeping a higher level of inventory may minimize stock-outs and cater to happy customers, but the risk of carrying too high a level of inventory means that the firm is exposed to obsolescence or higher-than-necessary carrying costs (including storage and insurance). If the firm decides to pursue lean inventory management by adopting just-in-time methods, it then runs the risk of suppliers disrupting the supply chain if they miss a delivery of needed parts for stock.
Managing payables has its own challenges. Stretching payables for too long may alienate the firm’s suppliers and hurt its supply chain. However, paying too quickly lengthens the cash cycle and increases the opportunity cost of cash.
What certainly helps in managing working capital involves setting realistic targets that one is able to manage, and evaluating actual performance vis-a-vis targets. Setting targets involves putting down on paper what are the target days sales outstanding, days inventory outstanding, and days receivables outstanding; and managing the working capital to hit those targets. Done at a very micro level, one may even set targets per customer that build up into an overall cash cycle target for the firm.
In addition to having a target cash conversion cycle, one may adopt other targets. These may include net working capital as a percentage of sales, aging of receivables, aging of payables, and the invoice error rate. Visibility on all of these metrics gives the firm the actionable information that it can use to maximize cash flow and optimize enterprise value.
Inevitably, when it comes down to target setting, the question shifts to who should be accountable for hitting the target? The answer is, everyone in the transaction chain -- from sales, to purchasing, to order fulfillment, to collection, to finance and treasury -- has a role to play in efficient working capital management.
Firms may adopt a bottom up approach in planning working capital management policies and procedures, where each participant in the transaction chain is accountable for hitting established target metrics or service levels. These target metrics become key performance indicators for the departments and individuals involved in managing working capital.
Planning, executing, and hitting working capital targets should be adopted as a continuous improvement process. While the benefits of solid working capital management strategies can be realized in the short to medium term, a company can also benefit from this in the long run thereby achieving an optimal business enterprise valuation. For the next article in this series, we will discuss working capital strategies that can be identified and implemented to optimize firm enterprise value.
Dec 10 2014
IN OUR SECOND installment of this three-part series on the importance of working capital in valuation, we talked about effective working capital planning, benchmarking, setting target levels, and managing working capital as part of a continuous improvement process. In this last installment, we will cover the actual tactics one can implement for effective working capital management. All of these tactics, applied on an ongoing basis, can help a firm optimize its cash flow and hence, its business enterprise valuation.
First, let’s cover what to do with idle cash. The cash on a firm’s balance sheet, if idle, represents an opportunity cost. If it isn’t placed even on an overnight basis, it isn’t earning interest. The company’s treasury could set up a facility with a bank where all of the idle cash at the end of the day, after all of the transactions have occurred, gets swept into an overnight placement. It earns an overnight money market interest rate. The next day, the funds are ready to service transactions.
As a counterpart to this, companies may also have short term lines with banks to finance their receivables. This comes in handy when accounts receivable collection efforts come up short against the forecasted figures. The company uses the short term lines to plug the liquidity hole in its balance sheet. Banks especially well-versed in facilitating commercial trade transactions will usually come forward to offer an overall financing package, which incorporates both the short term line and the sweep facility.
The next layer on the balance sheet after cash concerns accounts receivable. These are generated based on credit sales to customers of course. It is often said that an ounce of prevention is worth a pound of cure. The firm’s first line of defense in managing accounts receivable is actually doing a rigorous credit analysis of each customer with which it does business.
Based on such credit analyses, customers can be grouped into several tiers. Those who are least credit-worthy become strictly “cash-on-delivery” customers. Those who meet the credit standards and have a favorable payment history, are given the best credit terms. Ideally, credit evaluations occur regularly, at least once a year, where the credit limits per customer are further refined. A customer’s recent payment history should be given more weight compared to the overall account performance.
The second thing one can do in receivables management for the best customers is to set up automatic payment arrangements through an electronic facility. The advantages of this include timely payment, lower transaction costs, and convenience for both the customer and the firm. Further, the use of automatic payment system frees up manpower time. The system also has an auditable transaction trail which allows for ease of reconciliation.
A company can also offer a prompt payment discount. The terms might be 2%/10, net 30. This means that the customer can get a 2% discount if he pays within 10 days of receiving the invoice, otherwise the entire balance is due in 30 days. The trade-off that the firm has to manage involves the effective opportunity cost of the discount, compared to the effective money market yields available for its idle cash, and the cost of any receivables financing that it uses.
On a regular basis, the firm also has to monitor the aging of its receivables and focus on those customers that are habitually late in paying. Letting accounts receivable slide for too long hurts cash flow and increases the chances that customers will default. Being too tight on payment terms and badgering customers for payment may alienate them, and they may choose to take their business elsewhere. Sometimes however, it’s perfectly fine to “fire” a customer that habitually pays late and soaks up precious time and resources in terms of collection efforts, because the effort can be used more productively elsewhere.
For businesses that really need receivables financing badly, one can discount receivables with a bank or finance company, which is otherwise known as factoring. This can get quite expensive -- the finance costs from factoring can easily eat into profit margins.
From the management of accounts receivable, we move to inventory management, which, inclusive of work in process inputs, is a challenging effort. The complexity is further magnified with a supply chain that has a multitude of warehouses, which serve as both inbound receiving centers and outbound shipping points.
The techniques of minimizing inventory and yet maximizing customer fulfillment have gotten more sophisticated, but the end goal is quite simple: reduce the amount of cash invested in inventory. From the just-in-time systems that Toyota pioneered to manage its inbound parts supply chain, inventory management has progressed to using statistical techniques like six-sigma and lean principles to reduce costs, eliminate waste, shorten turnaround times, and improve customer fulfillment.
Lean inventory management techniques focus on five principles: value, flow, pull, responsiveness, and perfection (1). When applied properly, these five principles result in a company capturing additional surplus by moving inventory only when the customer demands it, using processes that have been optimized to eliminate waste and reduce time, benchmarked against clear metrics to identify further process improvements that can be made in the future.
Firms can also use up-to-date technology to magnify the efficiency of lean inventory management. Radio frequency identification chips (RFID) attached to products that enable tracking over the internet, allow the firm to know exactly where the entire goods in transit are at any given time, and can deter the incidence of inventory shrink. As a bonus, a link to the customer’s supply chain can trigger automatic re-ordering when the customer’s stock goes below threshold levels.
Managing accounts payable brings with it a new set of challenges. To lower cost, one can take advantage of prompt payment discounts. The prospect of getting a hefty discount compared to money market rates may be enticing, but one has to weigh the early disbursement of cash versus the next best use of that cash. You have to make sure that based on projected cash cycle, your cash flow won’t suffer if you take advantage of the payment discount.
If your cash flow won’t hold up, but you’ve got financing to cover it, you have to take into account the cost of financing, which will offset the early payment discount.
Another tactic to consider involves simply delaying payment on payables. This has its own risks, because suppliers can disrupt your supply chain by refusing delivery on your future orders. Before you do this, you have to think long and hard on whether the headache of having a potentially disrupted supply chain is worth the benefits.
The other thing one can do with respect to managing working capital, with perhaps the longest lasting consequences, involves running a process improvement program (like lean six sigma) on your entire working capital management process. Every error in every activity in the cash cycle has a real cost, or an opportunity cost. Multiple errors on the same transaction pile up, especially if you multiply those errors across the multitude of transactions processed.
If you reduce error rates, the cost savings in terms of time and money flow straight to the bottom line. This is why General Electric adopted Six Sigma after Motorola pioneered it. GE knew that if it could reduce error rates, the savings from eliminating errors in the millions of transactions it does every year would result in material additional profits.
Managing working capital optimally to increase firm valuation is a commitment. The additional sustained cash flow from managing working capital well, can actually have a material impact on a firm realizing its optimal business value. This becomes significant when the working capital metrics, when compared to industry competitors, are significantly better than the industry norms. In such a situation, the firm can actually command a premium from a prospective buyer, because in valuation, cash is king.
1 “The Scoop on Lean Inventory Management Techniques,” at www.blog.clientsfirst-ax.com
Raoul Villegas and Ma. Luisa Gonzalez, Director and Senior Associate, respectively, are from the Deals and Corporate Finance group of Isla Lipana & Co., the Philippine member firm of the PwC network.
(02) 845-2728
raoul.a.villegas@ph.pwc.com
maria.luisa.gonzalez@ph.pwc.com
source: Businessworld
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