Now, more than ever, organizations depend on Treasurers to be the fiscal watchdog. Most critically, Treasurers are asked to be the steward of the company’s most important asset: Cash. Everyone knows this asset is the life blood of an organization, propelling the generation of goods and services and the rewards that come along with their delivery. Treasurers also keep the organization running smoothly by forecasting what financial flexibility the organization can rely upon through various business cycles. Because when cash runs out, or if there’s even a question about liquidity, production is thrown off, or worse, grinds to a halt.

In this post we’ll take a look at age-old, tried and true methods to measure working capital and some of the simple ways to improve it. But we’ll also dive a bit deeper on new derivations of those strategies, mainly driven by enhancements in technology that make it easier than ever to achieve improvement.

The Mission Seems Simple Enough…

At the core, Treasurers strive to continuously improve and efficiently manage working capital and generate cashflows. While the mission seems simple, in practice, and with competing priorities, it can be difficult to deploy. Knowing where the company stands on working capital performance, how it compares to peers, the upside of improving, assembling a project team to make the improvements, and sustaining that change over time are not simple tasks. There are three parts to the framework that most companies use to improve Working Capital performance.

1. Gathering data and benchmarks for key financial metrics to assess performance and areas of improvement in working capital
2. Assessing, selecting, implementing, and utilizing solutions and best practices to solve issues and improve performance of working capital.
3. Deploying working capital savings back into the business to fund projects, investments, or pay down debt

In this post, we will focus on the first two parts of this framework, gathering data and benchmarks and assessing, selecting, implementing, and utilizing solutions and best practices.

Gathering Data & Benchmarks

Working Capital ratios and benchmarks are not new news, but these simple ratios can get lost and overlooked. The benefits of managing them tightly are simple ways to enhance overall financial performance.

There are three Key Performance Indicators that capture working capital efficiency:

• Current Ratio
• Turnover Ratio
• Cash Conversion Cycle

We will unpack each of these metrics to illustrate their benefits and remind ourselves of their power.

Current Ratio

First, Treasurers will look at their Current Ratio versus peers and historical performance to get a rough estimate of the company’s liquidity and working capital efficiency. This key ratio measures a company’s working capital (current assets over current liabilities). Here’s how that breaks down:

<1.0 Signals a company may have trouble settling current obligations in a crisis

1.0 Reasonable for liquidity purposes as it indicates that current assets are enough to cover current obligations

1.2 – 2.0 Ratio most business analysts believe to be considered satisfactory

>3.0 Indicates a company’s assets, working capital, or even their ability to secure debt financing are not being managed efficiently

Treasurers are reacting and directing meaningful changes throughout their organizations in order to improve these ratios by spearheading the management of the key levers of working capital (i.e. accounts receivable, inventory, and accounts payable). And their efforts are being noticed! According to the most recent Hackett Group Working Capital Survey, in 2017, the 1,000 largest US based public companies had their best working capital performance since 2008. US companies executed working capital efficiencies mostly by extending payables in reaction to the approaching headwinds of rising interest rates, and escalating raw materials costs impacted by inflation and global tariffs. Efforts were also made to harvest the balance sheet to support increased merger and acquisition (M&A) activity, CAPEX spend, and returns to shareholders in the form of increased dividends.

Turnover Ratio

Second, Treasurers will review the Turnover Ratio to measure how efficiently the company is deploying its working capital to support sales relative to peers and historical performance.

For example, a working capital turnover ratio of 5 indicates that the company is generating $5 of sales for every $1 of working capital deployed.

High Ratio | Indicates the company is efficiently using current assets and liabilities to support sales

Low Ratio | Indicates the company is tying up too much capital in AR and inventory to support sales

Analysts know that having excess capital tied up in uncollected AR can signify poor quality receivables, and issues with collections and chargebacks that foreshadow pending bad debt right offs. In addition, excessive inventory could be indicative of weak demand for products with the very real possibility that warehouse shelves are filled with obsolete inventory. In fact, these scenarios are being played out now on the average company’s balance sheet. It’s clear that while the largest US based public companies are executing improvements in working capital, smaller companies and global competitors are losing ground. Dry powder is now sitting in the receivables and inventory of most company’s balance sheets awaiting to be uncorked.

Cash Conversion Cycle

Third, the importance of how AR, Inventory, and AP drive a company’s Cash Conversion Cycle cannot be understated. This metric measures the time it takes to convert a cash outlay into a cash receipt. Treasurers also rely on this calculation to help identify and target what variables are causing inefficiencies in their working capital relative to peers and past performance.

The calculation is defined as Days Sales Outstanding (DSO) PLUS Days Inventory Outstanding (DIO) LESS Days Payable Outstanding (DPO)

While companies have focused on DPO to enhance working capital, a vast quantity of dry powder still remains tied up in receivables and inventory. According to the Hackett Group, the 1,000 largest US based public companies in aggregate have continued to leave over $1 trillion in working capital on the balance sheet, forgoing the chance to decrease their cash conversion cycle. To illustrate the impact of this inefficiency, a seven-day cut in the cash conversion cycle could return about a 1% improvement in margin through lower write offs of uncollected receivables, obsolete inventories, and by exercising trade discounts. For companies generating an EBITDA of 5%, a 1% pick up in margin equates to a 20% increase in profit.

Assessing, selecting, implementing and utilizing solutions and best practices

Once we’ve gathered the data, ratios and benchmarks, what do we do with them? How do we assess the data, select a path forward, implement that path and sustain it? Treasurers have long had access to a variety of tools to achieve this.

• Best Practices
• Bank Products
• FinTech; Treasury Management Systems; Supply Chain Finance Solutions
• Working Capital Assessments and Programs

The age-old issue still exists – change is hard, no matter if change is across a global enterprise or small business.

The good news is as new technology continues to mature, and integrations between workflow tools, ERP’s and banks becomes easier and more sophisticated, the power of the tools available has increased, and, in part, become easier to implement and sustain.

Let’s take a look at each of the tools.

Best Practices

Let’s not overlook the fundamentals of Best Practices that Treasurers use to improve the Cash Conversion Cycle when working with internal stakeholders, vendors, and customers.

• Extend DPO by extending terms with suppliers. This used to be a one-sided strategy, with buyers demanding extensions smaller suppliers couldn’t combat. Reverse factoring and dynamic discounting are not new ideas, but the level of technology sophistication and integration makes putting them to work much easier than ever before. These tools can be easily integrated with an ERP, Treasury Management System and other AP Automation technology.
• Reduce DSO by adjusting credit terms to shorten the number of days receipts are due from customers. But as mentioned earlier, this trend has been escaping most companies as of late as customers are trying to extend their own DPO at the expense of sellers.
• Review the credit approval process. Being smart about who credit is extended to can help a company avoid slow payments, no payments, and other administrative issues that tie up capital and time for the Collections staff. In practice, we know that some sales are just not worth the credit risk.
• Track AR aging, invoicing customers accurately and on time, and sending friendly reminders before payments are due is another way of reducing DSO creep.
• Get control of DIO involving demand planning to find the right product mix and levels of inventory on hand for sale. We know that too much capital tied up in inventory could reflect poor planning, weak demand, or obsolete products. However, too little inventory could put the enterprise at risk for losing sales that are unable to be fulfilled.

Bank Products

Treasurers have long relied on their partner banks for products to improve the Cash Conversion Cycle.  

• Companies can reduce DSO by performing a proximity study to ensure customers are issuing checks to the closest lockbox, or have invoices paid by ACH to eliminate check float. Accepting purchase card payments and negotiating reduced interchange fees will also increase cash throughput.
• Card Programs or Supply Chain Financing products such as Reverse Factoring can extend DPO by allowing a buyer to pay their vendors using the bank or finance company’s funds. This extends the original payable by nearly a month, with Card payments having the added bonus of providing rebates to the buyer. As we’ll detail next, Supply Chain solutions are also available from Fintechs in partnership with banks as funders.

Fintech

Fintech can be a confusing landscape, but at the core, the tools are relatively the same, just better and easier to use than in the past.

• Simplified, electronic payments and cash accounting in a Treasury Management System: Processing efficiencies from inbound and outbound electronic payments such as ACH or Card can easily be captured by a Treasury Management System to automatically clear AP, AR, post to the ledger, and relieve operations of manual posting and reconciliation functions. SaaS-based Treasury Management Systems with connectivity to banks makes this implementation much easier than in the past.
• Procurement and AP Automation: Companies can also achieve fulfillment efficiencies by utilizing Procure-to-Pay SaaS solutions to manage the supply chain vendor base, complete the three-way match of approved invoices, and govern the approvals and release of outgoing payments (and then couple with Supply Chain Finance for Dynamic Discounting or Reverse Factoring). Similar to Treasury Management Systems, the configurable nature of these SaaS platforms makes the implementation a much simpler process.
• Visibility into Cash Position and Forecasting in a Treasury Management System: OTC transactions that move working capital can be captured and aggregated into global balances by a Treasury Management System, allowing the Treasurer to have 360-degree visibility to consider along with debt positions, and FX exposures (and, again, coupled with Supply Chain Finance to release excess cash or extend terms via Reverse Factoring to create cash flow). A lot of Treasurers are beginning to see the power of a Supply Chain Finance technology platform embedded in their Cash Position and Forecasting workflow tools – i.e., the module for Reverse Factoring is integrated with the module for Cash Position.
• Supply Chain Finance solutions connected to Procurement/ AP and Treasury Management: As previously stated, this is coupled with a Procure-to-Pay / AP Automation solution, as well as enhanced knowledge about Cash Position and Forecast via a Treasury Management System. It used to be that these functions were siloed and not part of one integrated workflow. In the SaaS environment that is no longer an issue. The workflows can be integrated across platforms. 

Working Capital Assessments and Programs

The biggest challenge companies face when looking to achieve success in a Working Capital program is time and access to information. For example, reviewing the supply base in depth to determine applicable suppliers for a terms extension, the risk to the base, and then creating the program to make it successful is generally not a task most companies are built to absorb. And even with technology solutions easier to implement than ever before, understanding the players, the landscape, and which tools will help for each piece of the newly designed, integrated workflow is difficult.

It is a well-documented anecdote that most Working Capital programs fail because of lack of supplier adoption (in the case of a DPO extension). Mostly, that comes down to supplier segmentation (gathering data and assessing it), selecting a strategy, selecting a method to implement that strategy, and the arms and legs to tactically execute that strategy. In essence, the muscle to deploy a program that includes a lot of change and implementing new technology.

In summary, the age-old strategies and subsequent challenges to increase working capital are not new, but enhanced platforms and products are changing the landscape by increasing interconnectivity and visibility, making it easier for Treasurers to manage and grow cash flow. It’s worth re-looking at your working capital program now more than ever since there are several clear paths to increased performance.

To learn more about the best Working Capital and Treasury Management strategies watch our webinar: The Power of True Liquidity Positioning and Forecasting with a Treasury Management System

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