impact of working capital

8/20/2019 Impact of Working Capital

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INTRODUCTION:

Working capital management is important part in firm financial management decision.

An optimal working capital management is expected to contribute positively to the

creation of firm value. To reach optimal working capital management firm manager should control the trade off between profitability and liquidity accurately. The purpose of

this study is to investigate the relationship between working capital management and firm

profitability.

The four major components of working capital are:

. !ash

". #arketable $ecurities

%. &nventory

'. Account (eceivables

!ash:

!ash is defined as Demand deposit plus Currency. !ash is probably the least

productive asset you can have. )ot only does it not earn any thing* it actually loses

purchasing power as a consequence of inflation. There are three motives for holding

cash balances:

• Transactional motives++. To conduct day to day business of paying for

purchase* labor etc.

• ,recautionary motives++. To cover unexpected expenditure. &f delivery

truck breaks down* it must be repaired or replaced if you want to stay in

business.

• $peculative motives+++. -nusually good opportunities occasionally arise.

&f you have the money available* you can take advantage of these

opportunities.

#arketable $ecurities:

#arketable securities are financial securities that can be sold on short notice. They are

not cash* but they can be easily converted to cash on very short notice. They are a way of

holding cash but with attribute of earning interest. Thus they are )ear !ash Assets e.g.

-.$ treasury ills* Anticipation )otes* !ommercial ,aper* anker/s Acceptances.



&nventory:

&nventories 0raw materials* work in process* finished goods1 make up a large portion of

most firm/s current assets* and for many total assets. As such* the extent to which a firm

efficiently manages its inventories can have a large influence on its profitability. Thus*

keeping abreast of inventory policy is critical to the profitability 0and value1 of the firm.

&nventory can be broken down into three major categories*

A. 2rdering cost

a. 3ixed !ost4 stocking* clerical

b. $hipping !ost4 often fixed

c. #issed quantity discounts4an appropriate !ost

. !arrying !ost

a. Time value of money tied up in inventories

b. Warehousing !ost

c. &nsurance

d. 5andling

e. 2bsolescence* breakage* shrinkage

!. $tock 2ut !ost

a. 6ost sales

b. 6oss of 7oodwillc. $pecial shipping !ost

Account receivable:

Accounts receivable are generated when a firm offers credit to its customers. The first

thing that needs to be addressed when establishing a credit policy is to set the standard by

which a firm is judged in determining whether or not credit will be extended. This is what

known as 8 !s of credit.

. !haracter4 the willingness of the borrower to repay the obligation

". !apacity4 the capability of the borrower to earn the money to repay the obligation

%. !apital4 sufficient assets available to support operations 0as opposed to a firm that

under capitali9ed1

Working !apital:



Working Capital is the money used to make goods and attract sales.

The less Working Capital used to attract sales, the higher is likely to

be the return on investment. Working Capital management is about

the commercial and fnancial aspects o Inventory, credit, purchasing,

marketing, and royalty and investment policy. The higher the proft

margin, the lower is likely to be the level o Working Capital tied up in

creating and selling titles. The aster that we create and sell the books

the higher is likely to be the return on investment.

Working capital is an important issue during financial decision making since its being a

part of investment in asset that requires appropriate financing investment. 5owever*working capital always being disregard in financial decision making since it involve

investment and financing in short term period. 3urther* also act as a restrain in financial

performance* since it does not contribute to return on equity 0$anger* "1. Though* it

should be critical for to a firm to sustain their short term investment since it will ensure

the ability of firm in longer period.

The crucial part in managing working capital is required maintaining its liquidity in day4

to4day operation to ensure it/s smooth running and meets its obligation 0;ljelly* "'1.

<et* this is not a simple task since managers must make sure that business operation is

running in efficient and profitable manner. There are the possibilities of mismatch of

current asset and current liability during this process. &f this happens and firm/s manager

cannot manage it properly then it will affect firm/s growth and profitability. This will

further lead to financial distress and finally firms can go bankrupt.

&n traditional view of relationship between cash conversion cycle 0as measure of working

capital management1 and profitability is ceteris paribus. The shorter firm cash conversion

cycle* the better a firm profitability. This shows that less of time a dollar tied up in current

asset and less external financing. While* the longer cash conversion cycle will hurt firm/s

probability. The reason is that firm having low liquidity that would affect firm/s risk.



5owever* if firm has higher level of account receivable due to the generous trade credit

policy it would result to longer cash conversion cycle. &n this case* the longer cash

conversion cycle will increase profitability. Thus* the traditional view cannot be applied

to all circumstances.

=ilemma in working capital management is to achieve desired trade off between liquidity

and profitability 0$mith* >?@ (aheman )ast* "B1. (eferring to theory of risk and

return* investment with more risk will result to more return. Thus* firms with high

liquidity of working capital may have low risk then low profitability.

Working Capital Cycle

A useful mechanism for the small4business owner is the working capital cycle. The

working capital cycle can be defined as the period of time which elapses between the

point at which cash begins to be expended on the production or purchase of a product and

the collection of cash from the customer. The working capital cycle analy9es accounts

receivable* inventory* accounts payable* and equity and loans. As shown in the diagram

below* the cash flows in a cycle into* around and out of a business. The faster a small

business grows the more cash it will need for working capital and other investments.

2wners need to understand that the cost of providing credit to customers and holding

inventory can represent a substantial proportion of a business/s total profits.

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http://www.entrepreneur.com/article/0,4621,265235,00.html#%23



To help explain the diagram above* some items need to be covered. The two main

elements in the working capital cycle that absorb cash are inventory and receivables. &n4

stock products or work4in4progress items are examples of inventory. (eceivables are

established when customers owe the business money. 3inally* the main sources of cash

are payables* equity and loans. ,ayables are established when the business owes a

creditor money.

;ach component of the working capital cycle 0inventory* payables* and receivables1* has

a time dimension and a money dimension. When it comes to managing working capital*

most business owners will say that time is money. &f an owner can get money to move

faster around the cycle by collecting money due from customers more quickly or reduce

the amount of money tied up by reducing inventory levels relative to sales* the business

will generate more cash or it will need to borrow less money to fund working capital. As

a consequence* a business owner can reduce the cost of interest or have additional moneyavailable to support additional sales growth or investment.

As a helpful guide to small business owners* below are some Cif D thenE statements.

$ource: ,lanware.org



If a business owner …… Then ……

collects receivables from customers faster* they can release cash from the cycle.

collects receivables from customers slower* the receivables soak up cash.

can get better credit from suppliers* they can increase their cash resources.

can move inventory faster* they can free up cash.

can move inventory slower* they consume more cash.

Factors Inluencing Working Capital !erormance

3or most !32s* the greatest challenge with respect to working capital management is the

need to understand and influence factors that are out of their direct control* in order to

obtain a complete picture of the companyFs needs. The !32s span of control can be

limited in terms of functional silos* though corporate finance may well have some powers

of influence over operating units.

While organi9ations generally concentrate on the right processes* such as cash* payables

and their supply chain* they are less likely to take into account various internal and

external constraints that can dictate how effectively those processes are executed. 3or

example* the legal and business environments can have a significant impact on

performance. $imilarly* internal considerations as such as organi9ational structure* shared

systems* autonomous business units* multinational operations and even information

technology can impact working capital* creating barriers that can hinder a !32s ability to

truly understand* and therefore manage* the companyFs needs.

The human factor is another important consideration. &f management is focused purely on

top4line growth* insufficient attention may be applied to cash flow management and

forecasting. A hard4line focus on year4end or quarter4end results can produce a flattering*

but inaccurate* picture of working capital performance and lead to counter4productive

behaviour. !onsider the impact on working capital of a year4end sales push* where

production has been building up inventory 0which may not be the appropriate inventory1



to meet this artificial demand and the quality of receivables deteriorates during the early

part of the following year.

While there is no magical solution for effecting robust working capital management*

there are a number of prerequisites for gaining control of the complex process.

Cas" Flo# Forecasting

,roper cash flow forecasting is essential to successful working capital management. To

do this effectively* organi9ations must take into account internal and external working

capital drivers and consider the sensitivity of those drivers to changes in the business or

market.

Garious questions need to be asked: 5ow will unforeseen events impact working capital

requirementsH What if a sudden market downturn or upturn occursH What if the company

loses a major customerH What happens if a major competitor takes a significant action to

improve its market positionH $ince each of these could have a si9able impact on the

business* organi9ations must assume that the only certainty will be uncertainty* and

prepare accordingly.

&n addition to assessing the cash flow impact of potential events* companies should

consider the possibility of having to make additional working capital investments. ThatFs

because events could affect non4operational cash requirements such as investments* credit

ratings and the ability to service debt* as well as inventory* payables and receivables.

!ompanies must implement contingency plans that take a holistic view of the

organi9ation in the context of a variety of different challenging situations. This will help

minimi9e the adverse effects of unforeseen events and provide financial flexibility in

uncertain times by having working capital as a ready source of cash.



5ow can you manage uncertaintyH The three fundamental approaches are: control it*

predict it* react to it. The most successful approaches are based around one approach* but

contain elements of all three. #arket4leading companies* perhaps not surprisingly* are in

the best position to manage uncertainty* often enjoying the ability to control supply*

minimi9e inventory and apply payment pressure on customers. !ompanies with less

influence* however* must rely more heavily on a strategy of prediction. To properly

prepare for events and improve or maintain performance during times of uncertainty*

organi9ations must develop an objective* business4driven view of the role of working

capital. Without real insight into true working capital drivers* a company may be able to

produce a reasonably good consolidated forecast* but find that accuracy drops

considerably when it comes to producing divisional* operating unit or even a product4line

forecast.

$eyond $alance %"eets

The Balance heet comprises !ong term "ssets #real estate, motor

vehicles, machinery$ and %et Current "ssets. The word Working

Capital is oten used or Net Current Assets.

Thus our Balance heet appears as ollows&

!ong Term "ssets ',(((

Working Capital )*,(((

Cash in Bank +,(((

Total Capital -,(((

We defned Net Current Assets as Total Current Assets less Total

Current Liabilities



We subtract current liabilities items from current assets as follows:

&nventory 8*

(eceivables B*

,repayments I*

,ayables 0>*1!ustomer ,repayments 0*1

Working !apital "?*

-sing this format we can state than any reduction in the Working !apital figure* other

than for provisions for write4offs and write4downs* will generate the same amount of

cash. Thus if a customer pays -$J 8 that he owes to the organi9ation* the Working

!apital figure will fall be -$J 8* and the cash figure will be increased by the same

figure. This revised format is useful when designing spreadsheet financial planning

models for business plans or for internal reporting.

Income %tatement Osiris

Turnover *

!ost of $ales 08B*1

(oyalties 0?*1

7ross ,rofit "8*

=istribution costs 08*1

,romotion 0"*1Write4offs 0%*1

Administration costs 0*1

2perating ,rofit 8*

&nalysis

$alance %"eet Osiris Working !apital K$ales L

"?.L

&nventory 8* &nventory in days >I

(eceivables B* (eceivables in days I"

,repayments: authors %* ,repayments in days:authors

I

,repayments : printers %* ,repayments indays : printers

>

,ayables 0>*1 ,ayables 0%I1

!ustomer ,repayments 0*1 !ustomer,repayments

0'1

Working !apital "?* Working !apital >?



!ycle in days

;xplanation of the calculations

Working Capital igure '(planation

&nventory in days 0&nventory K !ost of $ales1 x %I8 M >I days. #ore correctly the

purchases figure* if available should be used* in this case excluding

royalties. Thus the publisher holds approximately " months of unsold

inventoryAccounts receivable in

days

0(eceivables K Turnover1 x %I8 M I" days. Assuming the turnover is

phased evenly throughout the year* this means the on average

customers take I" days to pay,repayments in days D

authors

0,repayment: authors K (oyalties1 x %I8 M I days. &n practice royalties

will be earned that reduce this figure while new advances are also paidto other authors.

,repayments in days D

printers

0,repayment: printers K !ost of sales1 x %I8 M > days. &n practice part

of the !ost of $ales figure would be new title pre4press costs not

carried out at the printer. This item relates to cases where advance

payments are made to printers as a deposit or for paper. The purchases

figure if available would give a more accurate figure.Accounts ,ayable in

days

0,ayables K0All purchases1 x %I8

0>* K 08B* N ?* N 8* N "* N *1 x %I8 M %I days

The purchases 0investment1 rather than the cost of sales figure should

be used if available. & have assumed that this figure includes money

owed to authors 0see prepayment: authors1!ustomer ,repayments 0!ustomer ,repayments K Turnover1 O %I8 M ' days

Working !apital cycle in

days

>I N I" N I N > 4 %I 4 ' M >?

Working !apital K $ales

L

"?* K * M "?L

'(planation o t"e igures

• 2n average it takes 2siris >? days to turn an investment into cash and profit.



• )ew tiles will use more Working !apital than reprints

• 2n average Working !apital equates to "?L of turnover

• The percentage of Working !apital to turnover varies according to the type of

publishing

• Trade publishing in developed countries may have a figure of between %84 '8 L

of turnover. Academic publishing is higher. ,rofessional publishing uses a lower

Working !apital L figure

• Working !apital is also a measure of risk

This figure may include new titles* reprints* foreign language coeditions* licence sales.

The figure would be different for each of these. Within the total alance $heet* the

Working !apital figure will vary throughout the year according to the phasing of newtitles and the sales cycle. ,ublishers should know the typical Working !apital cycle and

the level of Working !apital as a L of turnover for each market or distributor* for each

category of book.

T"e relevance o Working Capital to publis"ing in young economies

&n the 3$- Working !apital levels were controlled at government rather than factory

level. &nvoices were settled on standard credit terms. )on or slow payment was not amajor problem for printers and publishers. (isk was a government problem. Authors were

paid standard royalty rates and terms. &nventory levels and print runs were according to a

formula: in textbook publishing* 8L of the textbook requirement would be printed in

year * the remaining 8L would be used for replacement copies in subsequent years.

,ublishers* printers and distributors would negotiate for annual cash budgets but did not

have to concern themselves about Working !apital questions except where budget

moneys were delayed.

,rinting capacity was sufficient to produce local and other agreed requirements. Thus

textbook printing would commence in )ovember for the following $eptember. &n a

competitive open economy printers would have to offer discounts and credit to persuade

publishers to take the risk of early ordering. $chools would demand the latest up4to4date



editions. ,ublishers would have to borrow money from the bank or shareholders to pay

for the inventory.

3or young economies* the implications are as follows.

. &n young economies the first industries to develop are those with low or negative

Working !apital L to sales. )egative Working !apital is where the organisation

uses supplier credit or customer ,repayments to fund their day to day needs.

;.7. banks and financial services* retailers* distribution* industries with cash sales

or advance payments on signature of contract 0e.g. printers1. 2rganisations with

negative Working !apital use the money from their customers with which to

invest and to pay suppliers.

". !ompetition is fiercest among industries with low or negative Working !apital K

sales L figures. 3inancial entry barriers are lower and these industries are easier

to expand. 5owever profit margins are often lower because of the competition

0but not alwaysP1 and the failure rate among such industries among developed

countries is usually higher.

%. anks are attracted to industries with low or negative Working !apital K sales L

figures as cash and profits are earned more quickly

'. ;ntrepreneurs are attracted to industries with low or negative Working !apital L

figures

8. #ost marketing innovations in book publishing have come about through the

application of the above Working !apital concepts to creating additional sales and

expanding the market. #ost of the innovations introduced at the end of the

previous chapter were created by reduced the level of Working !apital and the

time schedule of creating and selling books.

I. The customers* suppliers and authors of book publishers also want to operate to a

low or negative Working !apital K sales L. Thus printers ask for advance

payments e.g. for paper* distributors will try to withhold payment until they have

received money from their customers.

B. ,rinters are loath to change from their dominant position where they could dictate

prices and schedules according to price scales formulated at state level. These



price scales were geared to maximum production output* not to satisfying

publishers and their customers under national or international competition. '4

colour printing would cost '4times the cost of single colour printing* despite the

introduction of modern '4colour sheet4fed presses. ,rinters will change their

attitude to pricing and print4runs only in a crisis. &n many young economies

printers have not co4operated with publishers 0partly the fault of the publishers1

and faced near collapse as publishers have purchased printing overseas.

?. &n developed countries publishers have sometimes allowed retail groups extra

credit 0M higher Working !apital for publishers1 in order to encourage them to

expand into new outlets or sell more books. &t is essential to distinguish between

genuine expansion cases and opportunistic entrepreneurs. The more a publisher is

actively engaged in marketing and distribution* the less likely is the publisher to

have to rely on offering credit as an incentive.

>. The concept applies equally to state enterprises and non4profit making

organisations. &f cash and profits are generated more quickly* new titles can be

commissioned sooner* staff and suppliers paid promptly. ank interest is reduced.

. Where producers are dominant* their customers will have to accept higher levels

of Working !apital. Where customers are dominant* the producers have to accept

a greater burden. &n some young economies* the government may have a policy of

holding key organisations in the state sector or as majority owned state enterprises

rather than encouraging a Cfree4for4all enterprise policy. This may affect printers*

publishers and distributors. This policy will affect the evolution of the Working

!apital cycle and may tilt it more in favour of producers.

Working Capital levels in book publis"ing in developed countries

Working !apital is a major problem in book publishing. #ost publishers solve the

question on a temporary basis by negotiating credit with printers and other suppliers.

Their own customers solve the problem by negotiating credit with publishers or

demanding Csale or returnE terms. C$ale or returnE terms make planning and cash

forecasting much more difficult. #ost publishers rightly prefer to offer a slightly higher



discount for a firm sale. (etailers will argue that they would not purchase many new titles

without their risk being mitigated by a Csale4or4returnE policyE

The central issues* which must be solved* are:

• &nvestment decisions rely too heavily on economies of scale e.g. in printing

prices* by amorti9ing first edition costs against larger print runs

• ,ublishers produce too many titles* which receive too little promotional effort and

thus sell slowly or not at all.

These can be solved only through long term changes in publishing strategy and greater

attention to the Cvalue chainE where suppliers* publishers* wholesalers and retailers co4

operate to mutual benefit and shared risk. 2n demand publishing may reduce inventory

levels but does not solve the marketing aspects.

#any publishers have studied the publishing of music !=/s and cassettes* and of greeting

cards with a view to finding solutions. While lessons can be learned* there are major

differences:

!=/s* cassettes and greeting cards

• Are all high margin projects

• !arry much heavier promotion budgets and commitment to marketing

• Are standardi9ed in format

• ;njoy few economies of scale so short run and on4demand manufacture are the

norm

• $ell to a more wide variety of retailers

• $ell on a less seasonal basis

,aperback publishers have adopted some of these aspects and have fought successfully to

overcome the low price perception of paperbacks. ,aperbacks can now sell in many cases

at the same price as a hardback edition. The creation of Chit4paradesE or CTop E listings

has been adopted for books of different categories and has attracted significant media



attention thus making books more fashionable. As a result books may sell faster* perhaps

at higher prices and thus reduce Working !apital levels.

)$ook !ackagers*

ook packagers create books under contract to publishers* book clubs or foreign

distributors. They evolve as part of the speciali9ation process especially when publishers

become larger and more bureaucratic. ,ublishers buy the rights for a territory for a period

of years or number of printings 0provided that the title stays in print1. The financial

attraction to publishers is that they can buy smaller print runs at economic cost. #ost

publishers will make advance payments to the packagers but may be able to approve the

content and design. #ost packagers prefer to sell finished books rather than license titles

on a film and royalty basis.

,ackagers buy at low prices from printers because they create only a small number of

titles but each title will have a large print run. ,ackagers often stay loyal to printers who

reward them with long credit and* in many cases* lower printing prices than those paid by

their publisher customers.

&n the TG world many program companies will create programs for several networks

while TG companies concentrate on distributing the programs. The production companies

will retain the rights and earn fees for repeat4shown programs. A similar situation exists

in the multimedia field.

Thus packagers are specialists who are not involved in marketing and distribution.

$ubsequently a small number of them have decided to become publishers and done so

very successfully after re4financing. #ost stay as packagers. !ompared with publishers*

these packagers have little market value in acquisition terms.

Thus packagers are very similar to many private publishers in young economies but with

important differences as the table below shows:



$ook !ackagers !rivate publis"ers in young

economies

4 3ounders are creatively rather

than market driven@ enjoy

CfreedomE

4 3ounders are creatively rather than

market driven@ enjoy CfreedomE

4 &nternational printers offer

them low prices and credit@

printers have often offered credit

to allow packagers to start up*

sometimes with dire results for

the printer

4 ,rinters tend to give better prices to

established publishers

4

$ome publishers may be closely linked

with a printer. The printer may demand

advance payment

4 ,ackagers usually allow

publishers to approve content

4 ,ublishers will not involve customers

in the book content except in special

cases e.g. textbooks and #inistry of

;ducation* -niversity ,ublishing

5ouses

4 (eceive advance payments

from publishers

4 Are paid after delivery

4 5old no &nventory but reprints

make high profits

4 Will often sell the total print run to a

single or small number of distributors

4 ,urchase rights from authors

and designers* and sell territorial

or other rights to a number of

customers

4 $ell books with no transfer of rights

The Working !apital cycle in both cases is similar in both cases. The reason is perhaps

the same. )either the book packager nor the young private publisher is adequately

financed@ both enjoy the creative aspects but do not want to expand if it means losing

control. There are few potential buyers for book packagers.



The cost of starting such organi9ations is much lower. Working !apital is lower because

they are involved only in creating the books. They influence distributors* retailers and

consumers only so long as they generate saleable new ideas. While book packagers can of

course sell foreign rights* their potential to sell reprints is lower.

+aking more eicient use o Working Capital

The table below lists items* which influence Working !apital levels favorably and

adversely

Items t"at reduce Working Capital levels orpublis"ers

Items t"at increase WorkingCapital levels or publis"ers

4 &ncreased profit margins 4 6ower profit margins

4 !ustomers who pay promptly

4 Advance payments by customers

4 6ong print runs except where all

the books are required on

publication e.g. $chool and

university textbooks

4 &nventory which is sold and paid for quickly by

customers after publication4 6ower &nventory levels by reducing print

quantities and working with printers who will

deliver quickly and produce low print runs

economically

4 $low authors who deliver late and

whose manuscripts requiresubstantial editing

4 5olding paper stock unless market

conditions demand and the savings

are large

4 $low schedules for the

development of new titles

4 $uccessful promotion that speeds up the rate of

sale

4 #aking advance payments to

printers

4 $easonal sales except where the

publishers prints only for the season

4 6icensing 0but problematic in young economies1



4 ,aying suppliers on completion with credit

4 Authors who deliver manuscripts on disk ready for

computer make4up

4 &ncentives to staff * authors * suppliers* customers *

sales staff and agents to speed up the rate of sale

and of developing new books* delivering

manuscripts on schedule

The attention of readers is again drawn to the examples at the end of the previous chapter*

which illustrate ways in which publishers have produced affordable books through a

marketing initiative. The concepts of this chapter apply in each example.

T"e danger o averaging Working Capital levels

2siris has a Working !apital to $ales figure of "?L. 5owever the figure will be the

average of the organi9ations different activities. 6et us assume that there are three

divisions that produce different types of books for different markets and use different

methods of distribution. The table below shows how each division generates much )et

!ontribution and also how much Working !apital is used in each division. The cost of

sales* royalty* distribution* promotion costs and write4off figures differ in each case as a

percentage of sales although not all the costs are necessarily variable. The term )et

!ontribution is the amount of money that each division generates towards the central

administration cost of the company and hence to profit. &tems below )et !ontribution is

not relevant to our analysis unless administration cost vary according to each market.

&nterest on bank loans could however be usefully charged against each division to give an

even more meaningful figure. Although a alance $heet item* Working !apital is shown

under )et !ontribution to highlight the relevance of comparing )et !ontribution and

Working !apital levels by division.



Income %tatement Division & Division $ Division C Total

Turnover I* %* * *

!ost of $ales 0%%*1 0?*1 0I*1 08B*1

(oyalties 0*?1 0I*"1 0*1 0?*1

7ross ,rofit I*" 8*? %* "8*=istribution costs 0%*>1 0*1 01 08*1

,romotion 0*1 0>1 0"*1

Write4offs 0*B1 0*1 0"1 0%*1

)et !ontributionOO >*8 "*? "*B 8*

Working !apital >*" B*? * "?*

OO 7ross ,rofit less distribution* promotion and write4offs. The contribution to

administration costs and profit from publishing activities

The analysis of the above sheds useful light on profitability and use of Working !apital

by division. This is discussed in detail below.

&nalysis o t"e net contribution

The table below shows each cost item included in the )et !ontribution calculation

expressed as a percentage of turnover.

Division & Division $ Division C &verage

!ost of $ales L to Turnover 88.L I.L I.L 8B.L

(oyalty L to turnover ?.L ".BL .L ?.L

7ross profit margin L "B.L >.%L %.L "8.L

=istribution L to turnover I.8L %.%L .L 8.L

,romotion L to turnover .?L %.L .L ".L

Write4off L to turnover ".?L %.BL ".L %.L

)et !ontribution L to turnover 8.?L >.%L "B.L 8.L

Working !apital K Turnover L %".L "I.L .L "?.L



The most effective programs for both improving working capital performance and

forecasting are those that look beyond the local organi9ation and consider the broader

corporate environment. !orporate investment and financing arrangements* for example*

may provide for cash to be delivered by one location* but utili9ed at others. (estrictions

on the repatriation of cash* internal inefficiencies in moving cash* delays driven by banks

and sometimes4inadequate access to information can make the process problematic.

!ash generated in one country* for example* many not have the same value to the

organi9ation as cash generated in another. As a result* companies must plan global

working capital improvement initiatives in the context of the ultimate use for the cash*

rather than simply managing local balance sheets.

Improving Working Capital +anagement

$uccessfully improving working capital management requires a multi4pronged approach.

!ompanies must seek granular detail to identify the underlying drivers of working

capital. This requires separating perception from reality and pinpointing impediments to

efficient cash flow* such as poor links between production and billing or clumsy treasury

operations.

!ompanies must also adopt an entrepreneurial mindset. They must act quickly to drive

change by combining operational and financial skills* and expand their thinking beyond

the finance organi9ation to gain a more complete view of overall operations. (ather than

wait for the perfect solution* they must identify and implement strategies that result in

quick wins* generating short4term cash to fund longer4term projects.



5aving the right people in place can also make or break the effort. !ompanies need to

identify individuals who can be responsible for setting targets and performance levels and

be held accountable for delivering. These professionals should be encouraged to

challenge the status quo and drive change* using cross4functional teams.

+easured &pproac"

3inally and this is where many projects fail* companies must remove emotion from the

analysis process. All initiatives must be business4case driven* and projects without

measurable results or those not contributing to overall goals should be abandoned.

!ompanies must agree on success criteria* prioriti9e based on contributions to these

criteria and continuously measure performance.

While working capital forecasting is critical to a companyFs ability to make informed

strategic business decisions* many !32s struggle with the process because of a lack of

control and real insight into the underlying drivers of their working capital needs. y

empowering the entire organi9ation to understand the companyFs true working capital

needs* companies can successfully reduce their financial risk* prepare for uncertainty and

create a ready cash reserve that will provide flexibility and security during difficult times.

,, Ways Companies +ay Improve T"eir Working Capital !osition

With interest rates continuing to rise* oil and commodity costs mounting and ever4

increasing pressures from Wall $treet to increase shareholder value* itFs surprising that

some companies are not taking more measured steps to drive effective cash management

and increase free cash flow.

Working capital is a highly effective barometer of a companyFs operational and financial

efficiency and effectiveness. The better its condition* the better positioned a company is

to focus on developing its core business. y addressing the drivers of working capital* in

fact* a company is sure to reap significant operating cost and customer service

improvement.



According to an analysis of financial results from the "* largest companies in the -.$.

and ;urope performed in "8 by 5ackett4(;6* -.$. and ;uropean companies have

reduced working capital by " percent and B percent* respectively* over the past three

years. This strongly indicates that awareness of the benefits of working capital and cash

management improvement has been elevated beyond the treasury to the office of the

!;2.

'(cess Cas"

ut while corporate profits may be soaring* corporations are still overlooking billions in

cash a staggering J'I billion in the -.$. and some J8B million 0QRS'I> million1 in

;urope. This enormous sum is literally stuck in transit* a result of inefficient receivables*

payables and inventory practices that could be reclaimed with relatively little investment.

5ackett4(;6* which is part of The 5ackett 7roup* a strategic advisory firm* calculates

that in the -.$. alone* getting this excess under control would reduce total net debt by ">

percent* increase net profit up to percent and improve return on capital employed

0(2!;1 from %.> percent to 8. percent.

6iberating the billions in cash trapped on the balance sheet is easier than one may think.

=ell &nc.* for instance a lauded for overall strong corporate management and working

capital performance builds a computer only when it has received payment for an order*

and doesnFt pay its own suppliers for an agreed4upon period of time thereafter. As a result*

=ell enjoys negative working capital and* the more it grows* the more its suppliers

finance its growth.

)ot all companies can operate like =ell* but most can improve their working capital

position by at least " percent over time if they pay attention to the following list of cash

management doFs and donFts:



,- .et educated/ There is more to working capital management than simply forcing

debtors to pay as quickly as possible* delay paying suppliers as long as possible and keep

stock levels as lean as possible. A properly conceived and executed improvement

program will certainly focus on optimi9ing each of these components* but also* it will

deliver additional benefits that extend far beyond operational rewards. All this

underscores the need for ambitious executives to integrate working capital management

into their strategic and tactical thinking* rather than view it as an extraneous added bonus.

0- Institute dispute management protocols/ !onsider a case where a companyFs

working capital is deteriorating due to an increase in past4due accounts receivable 0AK(1.

A review of the past4due AK( illustrates a high level of customer disputes* which are

taking on average of % days to resolve and consuming significant amounts of sales*

order4entry and cash collectorsF time.

y tackling the root cause of the disputes in this case* poor adherence to pricing policies

the company can eliminate the disputes* thereby improving customer service. ;stablished

dispute4management protocols free up time for sales* order4entry and cash collectionsF

personnel to be more effective at their designated roles* and they also will increase

productivity* reduce operating costs and potentially boost sales. And finally* days payable

outstanding 0=,21 and working capital will improve* as customers wonFt have reason to

hold payment.

This example illustrates how working capital is one of the best indicators of underlying

inefficiency within an organi9ation and why it is critical that senior executives remain

focused on addressing the primary causes of working capital excesses to control

operating costs and remain competitive.

1- Facilitate collaborative customer management/ 2ne of the most important cash

management and working capital strategies that executives !32s and treasurers* as well

as !;2s can employ is to avoid thinking linearly and concerning themselves solely with

their own companyFs needs. &f it is feasible to collaborate with customers to help them



plan their inventory requirements more efficiently* it may be possible to match your

production to their consumption* efficiently and cost4effectively* and replicate this

collaboration with your suppliers.

The resulting implications for inventory levels can be massive. y aligning ordering*

production and distribution processes* companies can increase inherent efficiency and

achieve direct cost savings almost instantly. At this point* payment terms can be most

effectively negotiated.

2- 'ducate personnel3 customers and suppliers/ A business imperative should be to

educate staff to consider the trade4offs between various working capital assets when

negotiating with customers and suppliers. =epending on the usage pattern of a raw

material* there may be more to gain from negotiating consignment stock with a supplier

instead of pushing for extended terms 4 particularly in cases of long lead4time items or

those that require high minimum4order quantities.

The same can hold true for customers. Would vendor4managed inventory at a customer

site provide you the insight into true usage to better plan your own productionH &t is

important to remember* however* that this is not the solution for all products* and it

should be evaluated on a case4by4case basis.

4- &gree to ormal terms #it" suppliers and customers and document careully/ This

step cannot be stressed enough. Terms must be kept up to date and communicated to

employees throughout the organi9ation* especially to those involved in the customer4to4

cash and purchase4to4pay processes@ this includes your sales organi9ation.

Avoid prolific new product introductions without first establishing a clear product4range

management strategy. Whether in the consumer products or aluminium extrusions

business* many companies rely heavily on new products to maintain and grow market

share. 5owever* poor product4range management creates inefficiency in the supply chain*

as companies must support old products with inventory and manufacturing capability.

This increases operating costs and exposes the company to obsolete inventory.



5- Don6t orget to collect your cas"/ This may sound obvious* but many businesses fail

to implement effective ongoing collection procedures to prevent excess overdue funds or

build4up of old debts. !ustomers should be asked if invoices have been received and are

clear to pay and* if not* to identify the problems preventing timely payment. !onfirm and

reconfirm the credit terms. 2ften* credit terms get lost in the translation of general

payment terms and whatFs on the payables ledger in front of the payables clerk.

7- %teer clear o arbitrary top8do#n targets/ Too many companies* for example*

impose a percent reduction in working capital for each division that fails to take into

account the realistic reduction opportunities within each division. This can result in goals

that de4motivate employees by establishing impossible targets* creating severe

unintended consequences. &nstead* try to balance top4down with bottom4up intelligence

when setting objectives.

9- 'stablis" targets t"at oster desired be"aviours/ #any companies will incentives

collections staff to minimi9e AK( over I days outstanding when* in fact* they should

reward those who collect AK( within the agreed4upon time period. After all* what would

stop someone from delaying collections activities until after I days when they can

expect to be rewardedH 6ikewise* a purchasing manager may be driven by the purchase

price and rewarded for buying when prices are low* but this provides no incentive to

manage lot si9es and order frequency to minimi9e inventory.

- Do not assume all ans#ers can be ound e(ternally/ efore approaching existing

customers and suppliers to discuss cash management goals* fully understand your own

process gaps so you can credibly discuss poor payment processes. Approximately B8

percent of the issues that impact cash flow are internally generated.

,;- Treat suppliers as you #ould like customers to treat you/ 3ar greater cash flow

benefits can be reali9ed by strategically leveraging your relationship with suppliers and

customers. A supplier is more likely to support you in the case of emergency if you have



treated them fairly* and* likewise* a customer will be willing to forgive a mistake if you

have a strong working relationship.

That said@ also reali9e that each customer is unique. -tili9e segmentation tactics to split

your customers and suppliers into similar groups. 3or customers* segmentation may be

based on criteria including* profitability* sales* AK( si9e* past4due debt* average order si9e

and frequency. 2nce segmentation is complete* it is important to define strategies for

each segment based around the segmentation criteria and your strategic goals.

3or example* you should minimi9e the management cost for low4margin customers by

changing service levels* automating interaction* etc. 3inally* allocate your resources

according to the segmentation* with the aim of maximi9ing value.

,,- Celebrate success in "itting targets/ ;mphasi9e the actions that helped you get

there. Ask your people to remember what it felt like when they hit the target so they can

motivate themselves to hit it again.

impact of working capital

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