The major components of working capital are: account receivables (A/R), account payables (A/P), and inventory. Cash is still king and the decisions and actions undertaken to obtain it require the strict reduction of a corporation’s working capital. Sweating your assets in this way, via lengthening or shortening payment cycles, factoring or other measures, can be beneficial to the bottomline but it needs effective treasury management.
Optimising working capital can sometimes lead to unintended negative consequences, and it can be counterproductive to a corporate’s business if it is not handled correctly. Let me elaborate on this concept. To optimise working capital a corporate treasurer must:
- Reduce A/R.
- Increase A/P.
- Reduce Inventory.
If these actions are performed in isolation, the chances are that the results obtained will dramatically backfire and result in deteriorating relationships with both suppliers and customers. That is to say, it could jeopardize the whole business of the company. In fact, if we look at the techniques frequently adopted by treasuries to increase A/P we find abundant literature (unfortunately) about companies that decided to pay their suppliers late, or even to simply suspend payments until further notice – neither of which are good long-term strategies.
Another usual tactic to optimise working capital is to make the supplier hold inventory and deliver only what is strictly needed for the production cycle. This sometimes unfair practice is often cloaked with an aura of “collaborative” or “on-demand” supply chain management phrases, while in reality it is, in effect, aiming to bluntly push costs back on to suppliers.
Such strategies steadily produce financial distress to the supplier and enhance the risk of its failure and, perhaps, the dissolution of a whole financial supply chain. This ultimately has negative consequences to the buyer. Besides being extremely short-sighted, this strategy is also myopic as it doesn’t consider another important factor; the importance of ensuring supplier loyalty.
In a globalised marketplace a supplier is serving not a single client, but a network of clients that are very likely competing against each other. So if a buyer is forcing that supplier to bare all the costs of the supply chain, chances are that the supplier will opt to loosen the relationship from the imposing client and prefer to work more for others. A disloyal supplier soon will turn into a supplier that will make very little effort to adapt to changing corporate requests. If that supplier provides key components (i.e. it is a ‘strategic’ supplier with a unique product), its lack of agility or effort will make the buyer less flexible and so vulnerable to market changes. And a company that cannot adjust to market changes will soon be out of business.
The situation on the A/R side is no different, and collaboration should always be remembered as an important guiding factor. One common practice adopted to reduce A/R, is to improve the collection of receivables by tracking aging credits and soliciting late payments from customers, which again though is very short-termist.
What happens to a company if such collection processes are not executed in a harmonised manner among the various departments? For example, what if a solicitor in the A/R department chases a customer for a presumably unpaid invoice only to discover that the delay had been agreed between the customer and the sales account? Or – after having threatened the client with a legal dispute action – the lawyer has to face the fact that the amount of the late payment is minimal versus the potential revenue sitting on a large contract that same customer is about to sign?
Don’t get me wrong. Working capital optimisation is indeed a best practice that corporate treasurers must strive for, but other factors must also be considered to mitigate the risk of adverse long-term consequences. Principally, attention must be paid to supply chain risk and liquidity management if such practices are to be used. Let’s discuss each separately.
- Supply chain risk: Responsiveness, reliability, and flexibility are indispensable performance attributes that participants in the physical and financial supply chain must reciprocally exchange to ensure streamlined operations and profitable results. Suppliers, distributors, freight forwarders, import and export agents, warehouse operators, and outsourcing partners, are but a few of the many participants and nodes of vast supply networks that are all involved. Before each one embarks on actions to optimise their own working capital ratio, they should look at the bigger picture to avoid likely negative domino effects.
- Liquidity management: Payments are becoming a strategic risk management asset for treasurers. Critical supplier relationships can be resolved by anticipating payments just for the purpose of maintaining the optimal level of loyalty. This decision – while apparently opposite to the dictates of an ‘orthodox’ working capital optimisation discipline – certainly helps to mitigate supply chain risk, ensures business continuity and, finally, represents a tool that implements a powerful and effective supplier relationship management strategy.
The bottomline to remember is not to look at working capital optimisation in isolation. Always remember you are a node of a vast supply network of interconnected and interdependent constituents and treat them as you would wish to be treated.
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