With many US corporations today facing the common challenge of large offshore cash balances, a revived focus to strategic cash flow forecasting has accelerated in corporate finance departments throughout America. They are attempting to meet their domestic financial obligations without taking on additional third-party debt. As a result, working capital management has become the main focus area for CFOs to challenge their treasury, financial planning and analysis (FP&A) and corporate controller groups, to minimise the working capital cycle and therefore improve free cash flow.
Importance of Working Capital
Working capital is the liquidity available to the treasurer to satisfy their company’s short-term financial obligations: current assets less current liabilities. Put another way, by optimising the various working capital components, treasurers can reduce the cash conversion cycle, which is the amount of time that cash is tied up in working capital.
The cash conversion cycle is comprised of days inventory outstanding (DIO), days sales outstanding (DSO) and days payables outstanding (DPO). As global economic growth slowed during the great 2008-09 recession, many corporations experienced working capital surpluses as inventory levels declined, DSO metrics stabilised, and global cash balances increased.
In recent years, as the global economy has returned to growth, treasurers are being tasked with proactively managing working capital as businesses expand into new markets and geographies, which can lengthen the cash conversion cycle by extending DSO and DIO. As an increasingly strategic corporate finance function, treasurers have a unique opportunity to work cross-functionally to drive working capital initiatives, track their effectiveness and positive impact to free cash flow.
Cash Conversion Cycle – Priorities and Business Implications
Before embarking on any working capital initiative, it is critical to collaborate cross-functionally to understand what implications a new working capital solution may present to the underlying business and its partners. Although the cash flow benefits of reducing the cash conversion cycle are clear from a treasury priority, it is important to recognise the components of the cash conversion cycle and how working capital optimisation programmes could impact the underlying business.
The goal of course is to minimise the cash conversion cycle by reducing DSO and DIO, while increasing DPO. However, if the focus is to improve any one of these metrics in isolation, there may be negative implications to other parts of the business. Inventory management, and specifically reducing DIO, is a good example of competing priorities between the treasury and sales teams. Higher levels of inventory may be important to the sales team to ensure they can meet demand and not forego a new sales opportunity. However, from a treasurer’s perspective, a growing inventory balance and DIO will have a negative impact to working capital, and ultimately free cash flow.
One component of working capital that has been the recipient of significant innovation in recent years is accounts payable (AP) and extending the company’s DPO. AP is the working capital component where corporate finance has the most control; however, treasurers must take an internal leadership role to educate and influence their corporate finance colleagues of these benefits. Corporate functions have a tendency operate in silos, where specific department objectives can be contrary to the overall strategic benefits for the company.
Utilising their leadership roles, treasurers can educate their finance colleagues of the strategic benefits of an effective working capital programme, which include improving free cash flow and securing internal low-cost funding (improved working capital being the lowest-cost source of cash). These groups include AP, procurement, legal and the broader treasury team. Historically treasurers and AP managers could delay payments to suppliers as a taxing method to extend DPO. The negative implications of this approach are apparent however, mainly stressing relationships with key suppliers and the resulting volatile cash flow levels within the quarter.
Most recently, supply chain finance (SCF) and related technology solutions continue to be an effective working capital tool to extend DPO. In a SCF solution, customers with strong credit ratings can often extend payment terms to their suppliers by involving a financial institution into the solution. Under a SCF solution, the supplier receives an accelerated, but discounted, cash receipt at a lower effective rate than they could finance externally, while the customer is able to delay their payable to the financial institution and thereby improve its DPO. Under this solution, the treasurer has extended the DPO, reduced the cash conversion cycle and improved free cash flow, while maintaining good relations with the supplier.
Treasurers, as safeguards of their company’s global cash and short-term forecast, have the responsibility to accurately monitor the future liquidity demands for their company. Treasurers can use this intelligence to align working capital and strategic cash flow plans against actual performance within the current quarter. Effective working capital solutions, including SCF programmes, can be strategic toolsets that enable the treasurer to proactively improve working capital, reduce the cash conversion cycle, and ensure short-term liquidity demands are satisfied and quarterly cash flow targets are achieved.
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