Thanks to the credit crisis, companies are scrambling for cash. Time to take a cold, hard look at the way you manage working capital.
The boom years made businesses careless with working capital. So much cash was sloshing around the system that managers saw little point in worrying about how to wring more of it out, especially if doing so might dent reported profits and sales growth. But today capital and credit have dried up, customers are tightening belts, and suppliers aren’t tolerating late payments. Cash is king again.
It’s time, therefore, to take a cold, hard look at the way you’re managing your working capital. It’s very likely that you have a lot of capital tied up in receivables and inventory that you could turn into cash by challenging your working-capital practices and policies. In the following pages, we’ll explore six common mistakes that companies make in managing working capital. The simple act of correcting them could free up enough cash to make the difference between failure and survival in the current recession.
Mistake 1: Managing to the Income Statement
The first favor you can do your company in a downturn is throw any profitability performance measures you may be using out the window.
Suppose you are a purchasing manager and your performance is judged largely by your contribution to reported profits. Chances are, a supplier will at some point propose that you buy more supplies than you need in return for a discount. If you accept the offer, you will have to lock up cash in holding the extra inventory. But since inventory costs do not appear on the income statement, you will have no incentive to turn your supplier’s offer down, even if you take the trouble to calculate those costs and find that they are greater than the gains from the lower prices. In fact, if you do turn the discount down, your compensation, which is linked to the income statement, is likely to suffer, even though your decision may be good for the company.
Whether they’re in manufacturing or in services, companies that hold managers accountable for balance sheets and not just profits are less likely to fall into that trap. Managers will have every incentive to explicitly measure and compare all costs and gains in order to determine the best course of action.
The same argument applies to all the components of working capital. Take receivables. Let’s assume that you are contemplating reducing your terms of payment from 30 days to 20 days. You assess the likely impact on customers and estimate that you will have to reduce prices by 1% to compensate for the tighter terms and you will sell 2% fewer units, which will lead to a drop in after-tax operating profit of $1 million this year. On the other hand, if the company generates $2 million in sales per day, shortening receivables by 10 days would free up $20 million in capital. Assuming an opportunity cost of capital of 10% (that is, you could make alternative investments that would generate a 10% return), you should be willing to sacrifice up to $2 million in profit per year to get your hands on this capital. The decision, then, is quite clear: If you estimate that profits will fall in future years in excess of that $2 million, you probably should not reduce your payment terms. But if you estimate that the profit loss will be less than the return on your $20 million, you definitely should.
A metals refining firm that had extraordinarily high levels of receivables in its Japanese business illustrates precisely this calculus. Following the company’s acquisition by a private equity firm, managers started requiring salespeople to call customers a week before their payments were due to remind them. The salespeople were predictably horrified. “This is going to drive customers to the competition for sure,” they protested.
The incoming senior vice president countered their objections by asking a simple question: “How would your customers feel if we deliberately delayed shipping their products until after the agreed-upon date? Would they hesitate to call us?” “Of course not!” the salespeople responded. “So then why should customers that consistently pay late be surprised when we call to remind them that their payments are coming due?” With this perspective, the sales force enthusiastically started calling customers to encourage on-time payment. As a result, receivables fell from 185 days to 45 days, putting the equivalent of $115 million in recovered capital back into the bank account and reducing capital costs by $8 million a year. Sales did decline, but the resulting loss in margin was only about $3 million. The reduction in receivables clearly outweighed the loss in sales from demanding faster payment. This is the sort of trade-off that we urge all companies to consider.
