Cash: The Life-Blood Of The Organisation
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How Best Practices in Working Capital Management Can Improve Cash Flows and Business Performance
Shiron Gooneratne
In today's competitive marketplace, where product cycles are ever shorter than before, pricing power is mostly non existent, and technology changes are rapid, delivering financial results have become one of the most challenging tasks for the business enterprises. Traditionally, top priorities of business organisations had been on the Profit & Loss Account where the main focus was on growing sales and profits to increase shareholder value. However, in an era where shareholders expect more value with less resources, companies have started looking for other avenues to improve financial performance of companies such as efficient management of working capital.
Some business managers are puzzled as to why there are continuous cash flow issues despite achieving good top line and bottom line results, without realising that money earned had been blocked unnecessarily in working capital. Although top line and bottom line numbers are important, the true performance of the business is reflected in the cash flow which is highly depended on good practices on working capital management. Inefficiencies in working capital management can result in anaemic situations for organisations. Symptoms of these organisations are: inability to meet the pay roll, pay vendors, statutory payments and so on. In this type of enterprises, the urge to search the daily mail for incoming cheques is just not a greed or lust - its is often a survival issue.
Efficient working capital management could significantly influence to increase the shareholder value of business organisations. In Sri Lanka, it seems that although companies have started realising the importance of managing working capital efficiently, not many new practices have been introduced to improve the working capital management in many organisations. However, Working capital management has to be a significant aspect of enterprise management. Its importance mainly comes from two reasons: Firstly, investment in working capital represents a substantial portion of total assets of a business enterprise. It appears that more than 60% of assets of a business enterprise are on working capital. Investment in working capital does not give a direct return to the business although working capital is a must for any enterprise. Therefore, inefficient management of working capital may result in tying up funds in unproductive assets which do not give a direct return to shareholders. Secondly, improper working capital management which could result in stock out situation could result in irreversible effects on the business.
Working capital can result in releasing tied up home capital which can be used to finance the growth and other important areas of the business.
In terms of interpretation of working capital, it can be defined as liquid resources available for routine operations of the company. Working capital is the term mostly used to summarise the financial resources available for a company's routine operations. These should be liquid resources able to cash when required in the short term. These liquid resources are mainly accounts receivables, inventories (and cash). The primary use of current resources is to pay debts as they fall due. As a result, working capital represents the difference between the current assets and current liabilities.
Strategies for enhancing Enterprise Liquidity by Managing Working Capital
Managing working capital efficiently and effectively is hardly a novel corporate strategy. Traditionally, it has been a cornerstone of good financial housekeeping in some business organisations for many years. However, the framework of managing working capital has started changing to a great extent over the last few years. These changes are mainly driven by business dynamics and information technology. Traditionally, the task of working capital management was perceived as a finance function of business organisations. Although this perception has changed to an extent over the last years, still some companies have the same perception although there is some element of cross-functional support in managing working capital management. This can be substantiated with the research carried out among companies in Sri Lanka. These companies highlight the perceptions and realities of working capital management: Some companies perceive working capital management as a finance issue, it is a balance sheet item, and it can be improved only with system implementations and has a negative impact on customer service and generate little benefit. However, the reality is that working capital is an operational issue, it has an impact on P&L, it can be improved with new policies, it improves customer service and it is one of the fastest ways to enhance shareholder value. To minimise the gap between the perception and the reality some companies have made a conscious effort to have the top management commitment and cross-functional support to manage working capital efficiently and effectively. Many American and European companies reward employees on performance basis. Most of these companies have included working capital management as a key performance indicator in performance management across the company. As a result, working capital has become an important aspect in remunerating employees across the organisation.
So, for Sri Lankan companies also it is high time to recognise that working capital management is a key effort priority in the enterprise management agenda. It is imperative to have working capital management in company business plans. This could include, setting ambitious working capital targets and key performance indicators, responsibilities and accountabilities, linking working capital achievements to incentives and performance related bonuses and so on. Planning is useless unless effective tools are in place to monitor the implementation. There are many effective, but simple tools such as PDCA (Plan, Do, Check, Act) which can be used at monthly management meetings to review the progress of working capital management and take required action. Many CEOs would get a shock if they see the unproductive assets hidden in the balance sheets such as excessive inventories, long overdue debtors which seem like no body's business. In an a period where interest rates are sky rocketing, improvements in working capital can result in releasing tied up home capital which can be used to finance the growth and other important areas of the business.
Measurement of Working Capital
If you do not keep a score, you are just playing a practice game. Therefore, measurement or keeping a score of working capital plays an important role in working capital management. To monitor the performance and financial stability/liquidity of the company, having a correct measurement is imperative. Two of the widely accepted measurement tools in working capital management are the current ratio (Current Assets divided by Current Liabilities) and the quick ratio (Current Assets minus inventory divided by Current Liabilities). Working capital has traditionally been considered a positive figure in the balance sheets of companies. A higher ratio of assets to liabilities was perceived as good performance. For example, Rs.20 million of current assets compared to Rs.10 million current liabilities is a current ratio of 2:1. This preference has mainly come from banks and other lending institutions, which see working capital as liquid resources that can be used to repay debts. Bankers have a mindset of looking at financial ratios and numbers that exceed pre-set standards. However, these perceptions should be challenged. It can be argued that high working capital levels are a strain on financial performance and a burden on company finances, therefore undesirable. Current assets that do not contribute to return on equity could hinder the performance of the company and may hide non realizable assets such as obsolete inventory that may not be sold or receivable that may not be recoverable. Therefore, the emphasis and focus should be on reducing current assets and funding current assets from non interest bearing finances such as trade accounts payable and home capital such as retained earnings. In other words, cash collected from sales is used for payables and with only a minimum amount left idle in the current assets.
Another emerging trend in western countries is to focus on zero working capital. Argument for this is, current assets should be less than the current liabilities and as a result there is no investment in working capital as the working capital is zero or negative. Some of well reputed companies such as Campbell Soup, General Electric, Quaker Oats and Whirlpool, have successfully, implemented Zero working capital concept. Big companies in Sri Lanka may consider implementing Zero working capital. But for small and medium sized companies, it may not be easy implement Zero working capital due to weak positions in bargaining power and ability to influence.
Key Constituents of Operating Working Capital
Debtors/Trade Credit Management
Credit is like an interest free loan given to customers. Credit, is emerging as an indispensable tool in sales management of business enterprises. Marketing and Credit Managers often use trade credit extension on two sales related grounds
• Its convenience and interest free financing may trigger larger purchases , increasing the company's overall sales
• It builds goodwill and gives the supplier greater stability because of more consistent repeat sales. Therefore, credit can be used as a tool to attract and retain customers.
Credit management mainly covers Credit Policies, Credit Control and Monitoring. With debtors constituting more than one third of the total assets of many firms, the management of accounts receivable is paramount to the survival and success of every business .But as per research , only handful of companies in Sri Lanka have fully documented and robust credit policies.
Inventory
Inventory management is an area in working capital management where the practices have changed to a great extent over the last decade mainly due to technological changes and also due to competitive reasons. Inventory management is concerned with keeping products and quantities in hand while at the same time having an adequate inventory balance to earn a reasonable return on investment. Proper inventory management is imperative to the financial health and sustainability of the business because being out of stocks force customers to turn to competitors, resulting in a loss of sales. Excessive inventory can result in large inventory carrying costs.
Inventories function as a shock absorber between sales and production. If this shock-absorbing role could be reduced, then the level of inventory could also be reduced. This is the essence of the Just in Time Inventory Management system developed in Japan now widely used in other countries. The focus of the just in time method is on redesigning the production system. Reduced investment in inventory ideally comes as a buy product of this re engineering process. Over the last decade supply chain re-engineering has become an important area to achieve competitive advantage. Enterprise Resource Planning has emerged as an effective tool in supply chain re-engineering, which has a direct impact on inventory management.
Optimisation of inventory level through Supply Chain Management (SCM)
SCM systems have been at the core of many re-engineering projects. The rewards of doing so can be substantial: optimum inventories and reduced working capital, better profits and productivity, and competitive advantage. Enterprise Resource planning (ERP) has played a key role in re-engineering the supply chain in many companies. Enterprise Resource Planning (ERP) which integrates the internal software and processors of the supply chain of companies have saved millions for multinational corporates and local companies on reduction of inventory level. Companies like Wal-Mart , Dell , IBM have shown that superior supply chain management through ERP contributes not just to a healthier bottom line, but also the industry dominance.
Accounts Payable (Trade Creditors)
Accounts payable can be considered as a spontaneous financing source because it is generated from routine operations of the company. When the materials and other supplies are purchased on credit, a source of interest free financing is created. Accounts payable is an important area to improve the efficiencies of the working capital cycle of business enterprises. However, it is evident that much attention has not been paid to this area compared to accounts receivable management and inventory management in spite of simple but attractive opportunities available to improve the financial performance of a business enterprise.
Conclusion
Best practices in working capital can greatly improve the cash flows and performance of the company. Profit is a good performance measure. However, profit can also be thought of as a figment of the accountant's imagination, especially since there is so much room for legitimate interpretation, judgment and flexibility in determining the profitability of the business organisation. Cash, however is cash. It is precisely measurable and absolute. Improved cash flows due to Managing working capital effectively and efficiently will allow business managers to concentrate on other more enjoyable aspects of the business such as growth, strategic initiatives, and so on. Working capital management is emerging as an indispensable element in the success and continuity of the business. Business organisations are different to each other. But working capital and cash flow concerns are the same for every business.
Shiron Gooneratne (shiron@smcsl.com) is the former Finance Director of a Fortune 500 company operating in Sri Lanka. Currently he is practicing as a Financial Consultant.