More and more the real measure of business success is recognised as the extent to which a company can produce returns greater than the cost of the money it needs to invest. Ultimately, this comes down to a simple matter of cash – though the processes required to release it are far from simple.
Getting this relationship right is an involved but feasible process.
Experience across the world shows all aspects of revenue, expenditure and supply chain management need to be addressed in a co-ordinated effort to realise the maximum potential of a business. The result in terms of very much lower working capital requirement and improved equity value can be remarkable.
Inevitably these issues cannot be left to individual treatment, but need to be co-ordinated as a top priority of business leaders themselves. Consequently the need for both awareness and application of new and better metrics to determine company performance is increasingly attracting the attention of business writers (vide Fortune Magazine and The Sunday Times recently).
Take the common scenario of late paying customers. The unpalatable fact may well be that if your customers have a habit of not paying on time, it is your own company discouraging them. Utter nonsense? If it happened to Europe’s largest electronics companies, Philips and Quante, why not?
The real answer to these two companies diverse problems has been to make the reduction of working capital requirement a management priority.
Implementing this approach globally for such companies has been the basis of consultancy group REL’s business for the last 30 years. The four benefits it yields are powerful.
First, funds freed from inventory and accounts receivable become part of the corporate cash flow. These liberated funds can be used to reduce debt, finance product development and new technology, and fund brands and expansion into new markets.
Secondly, a decrease in working capital provides a permanent increase in earnings as companies save by drawing less on bank borrowings and other sources of working capital.
Thirdly, working capital reduction requires changes in processes that result in significant efficiency gains and cost reductions which, in turn, directly improve profitability.
Finally, these same process changes lay the groundwork for powerful service improvements that considerably enhance margins and customer retention.
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It is now being widely recognised that a concerted approach to improving capital efficiency can be the key driver of improved shareholder value, through a focused approach to the control of working capital. “Free cash flow” is the ultimate source of any company’s wealth creation and therefore share price and market value. This in turn comes from an organisation’s success in growing its revenue and maximising its operating income, or cash provision.
Using that cash efficiently determines the company’s rate of cash consumption.
The difference is the level of “free cash flow” available to build an organisation’s strength, wealth and overall value. Whatever set of metrics are used to measure an organisation’s performance this methodology will show through to an organisation’s management, shareholders, and everyone else concerned.
The whole question is one of liquidity management and its importance to corporations. Cash flow is fundamental to good business. If it is not right other unfortunate things such as margin erosion can spring come from it. Between a standard list price for a product and net revenue received, all sorts of things may happen – including dating, term discounts, invoice discounts, co-operative advertising, demonstration costs, pricing, returns, unauthorised breakages and sometimes a bad debt element.
All those things could be happening, perhaps often, and spread across many different departments. This means only a cross-functional team can sort it out. To get the people in a company to buy into it they have to understand the relevance of their actions to their other stakeholders through an effective analytical process. If they can all be shown clearly where the margins are leaking away, and where these are cross-functionally determined, people readily understand why it is important to do something about it.
Unfortunately, many middle echelons have, over time, led their finance director to believe they are best of breed and there is no other way.
It is these good and earnest people who have to be shown that it isn’t true and that by doing things differently they will do them much better and probably more easily. Lower down, it’s easier. There is seldom any resistance from the people on the shop floor – who tend to say we have been telling them for years if they could only get that right there wouldn’t be a problem.
The things that have to be done transcend individual responsibilities.
To make it work, any FD has first to get alongside his sales and marketing, as well as his manufacturing people, who might well have all sorts of other things going on and whose agendas could well be very different.
What doesn’t work in this context is an improvement in one area and an unrelated improvement in another. A cross-functional view of the whole business is vital, with implementation of the necessary changes right across its structure.
Achieving that balance requires consensus but the evidence is that rational people provided with rational information will come to rational conclusions.
If they understand the relevance of an action to all the other stakeholders, thrown up through detailed analysis across functionality, they will be prepared to do things differently.
If people can clearly see the sales process is being screwed up and is resulting in elongated receivables at the end of the cycle, they will accept the need for change. If a sales manager sees an accurate analysis of the discrepancy flow in the business he will quickly realise (if unhappily) that 30%, say, of the salesmen’s time is being spent in rectifying past errors rather than selling new business. With that knowledge he can seek greater productivity from his salesmen and in the process improve his company’s working capital performance as well.
On the positive side this may mean that quite soon within the billing process and within the 30 days, there should be a follow-up checking pleasantly with the customer whether they received the order, at the right time, with the right paperwork, and were happy with it – in which case can we expect to be paid at the agreed time? And if the reply is negative because it wasn’t right – wrong product, wrong time, wrong place or whatever – the company needs to know about it, analyse it, and find out what its people are doing wrong.
This enables a company to re-engineer the front end of the process – credit policy, pricing policy, billing accuracy, dispute causality, collection structures – all the things that happen prior to the sale. The whole process then becomes a continuous improvement cycle, designed to prevent a lot of inaccurate bills with wrong amounts, wrong descriptions, even wrong addressees going to the wrong place or even the wrong accounting department – a large company, utility or local authority may have endless different payment points.
The process therefore also involves understanding the other end – your customer and what their structure is – who does what, when, and how many people are in the whole process. What are they doing, when are they doing it, should it be sitting with the customer service unit, should it be sitting with a separate office, and so on.
Threats of litigation over disputes or interest being charged is not normally something to be recommended, although of course there has to be a long-stop procedure of some kind which is relatively easy to set up. Sensibly the whole emphasis needs to be not on litigation and disputes – even though companies need to know about them – but on delivery and quality service to customers. The best way of managing a cash flow is by being a better business – Michael Heseltine should remember it costs six times as much to start up a new customer as to service an existing one.
Implementation can produce very significant improvement in the indicators for the accounts receivable area – DSO (day’s sales outstanding), overdues, roll over (what is rolling into overdue), dispute management, and productivity.
Indicators in accounts payable include inventories, cycle times and industry turns. From a strategic standpoint return on net assets can typically improve by 15%-25% although in one exceptional case that follows it was 55%. Economic value added is 20%-32%, present value cash flows 17%-28%; and dead equity ratios can be anything. In one particular case there was a 60-40 dead equity ratio which turned around into 40-60.
Typical improvements in accounts receivable are somewhere in the 25%-30% range; inventories equally about 25%; accounts payable 10%-15%. When you do the aggregate of those, you find you are improving networking capital by about 40% – as some work for each other, some against each other.
Take a representative substantial business – not a global business but a #300m sales business making quite slim margins. Looking at the balance sheet, receivables, inventories and trade creditors give a total working capital position of #61m. The changes that could be brought about on those receivables using a database to compare industry by industry performance indicate the company’s potential performance: improvements of #25m, reducing the working capital to #36m.
Apply simply the interest savings on that, the most conservative way you can possibly judge it (because most people when they are looking at #25m will say “What is our alternative investment opportunity?” rather than “Interest rates are currently 7%.”). Apply that to the NPBT ie #2m roughly taking 8%. Then apply that new ratio to the net asset figure and you end up with an improvement of 18%-28% which is a 55% improvement in return on assets.
And that does not include anything relating to where the company is selling or to the shape of the business. No fancy stuff, simply addressing what it is doing now and then doing it significantly better, with senior management and everyone else buying into the programme.
The greatest challenge is to work successfully with the people who ultimately have to weave executive management’s vision into the fabric of the organisation through their day-to-day operations. Taking a general management perspective is vital and if any general manager can find a way of improving his company’s assets by 55% any other way within a year or two years, let him hold up his hand.
In particular, any publicly quoted company that can do this within 12 months will find the financial analysts getting very excited when they start to see the numbers turning round.
Jack Welch of General Electric wrote in Industry week in 1994: “We always say that if you had three measurements to live by they’d be employee satisfaction, customer satisfaction and cash flow. If you’ve got cash in the till at the end, the rest is all going to work – because you’ve got high customer satisfaction, you’re going to get market share. If you’ve got high employee satisfaction, you’re going to get productivity. And if you’ve got cash, you know it’s all working.”
Christopher Bielenberg is chairman of the REL Consultancy Group.