Fresh Thinking with Respect to Cash

Working Capital Optimisation and Cash Flow Management author John Mardle looks at why fresh thinking is needed in regard to Working Capital.

by John Mardle

Working Capital is at the top of every CFO's agenda, according to CFO Europe Magazine and Global Treasury News, which is a change from the 'Cinderella' status it held for much of the boom times. So what has fundamentally changed?

1. Firstly credit is hard to come by for most organisations and if available it is increasingly made expensive by fees, penalties for not hitting targets and very tight rules regarding terms of repayment.
2. Secondly working capital has normally focused on traditional metrics like DSO, DPO and DIO but in today’s world these metrics need to be ‘developed’ by enhanced metrics ( or as we call them ‘drivers’) that identify the real issues as to why DSO has increased or DPO has decreased.
3. Finally Working Capital needs robust and consistent financial commentary as investors, stakeholders and employees rely on such information to appreciate the cash conversion cycle (CCC) and whether there are issues that need to be addressed in future cash flows. Regulatory bodies like the Financial Services Authority and the Audit Practices Board are also keen to ensure this area is highlighted in all future reporting with the Accounting Standards Board going further in deciding to review and consult on major parts of working capital and in particular Work in Progress.

We need to Challenge some traditional perspectives

By definition: working capital = current assets - current liabilities

Working capital is useful to show the operating liquidity of a company and how the company manages its business, but traditional measures could be giving false signals.

It is traditionally a computation that is augmented by the use of days sales outstanding (DSO) when describing how long it takes an organisation to collect its invoiced debts from its customers, by days purchases outstanding (DPO) when analysing how late suppliers are being paid, and by days inventory outstanding (DIO) when appreciating how quickly stock is turned into cash.

However, in today’s service driven economy we need to look at inventory as ‘work in progress’ which can make this difficult both in terms of value and ‘timing’. This is because the service and construction sectors have the additional complication of ‘time’ ascertainment either via timesheets or work logs. Allocating costs of labour is prone to many types of errors and therefore could cause sales and purchase invoices to be rejected and so valuations of work in progress can become very subjective.

When we look at the assets of the balance sheet, accounts receivables is listed under assets but when you start thinking about working capital it should actually be under the liabilities section.

This is because the amount of accounts receivables is really just an interest free loan to the customer. The company has not received the cash for the bills. It is only when account receivables decrease that cash flow increases. This is what the term "changes in working capital" refers to. The working capital change on the balance sheet impacts the cash flow statement.

Inventory is another major component of working capital and can also be considered a liability while accounts payable will add to positive cash flow because it is money that you owe but haven’t paid yet. So it's like an interest free loan that increases your cash flow.

Working capital also has it own set of disadvantages

Current assets and liabilities are fairly easy to manipulate and depending on the accounting method, the amount will vary considerably. E.g. a company using the LIFO method will have a much lower inventory value compared to a company that uses the FIFO method to value inventory. The two companies could have exactly the same set of products in their warehouses, but depending on whether they use conservative or aggressive accounting, there will be big differences.

Working capital can also vary drastically year to year which could provide an inaccurate picture of the business as well as affect the projected growth rate.

But there is no right or wrong. It just depends on how you view a business and investment.

New thinking

There have been a number of changes in tackling working capital and cash flow short comings:

1. CIMA generated a consultative document on revenue recognition,
2. the FSA applied more stringent criteria to the banking fraternity so that loans for working capital are harder to come by,
3. the audit practices board requested that auditors state whether an organisation can satisfy its banking covenants in the future and to generate a ‘going concern’ Statement if that is not the case.

However major organisations are addressing many of the above issues by imposing a supply chain management approach which ensures that suppliers are firstly 'vetted' to ensure they comply with the organisations supply requirements regarding quality, price and other process type criteria. Some organisations are then applying financial constraints to ensure payment to suppliers moves from 60 days to 75 days from end of week the suppliers invoice is 'processed.' This is causing working capital issues for smaller suppliers, and unless rigorously monitored to ensure that these smaller suppliers are not detrimentally impacted, it could significantly affect the supply chain and major organisations might find themselves without vital supplies, which in turn would impact their ability to satisfy customers.

Other organisations are applying a Demand Chain Management approach which ensures there is a customer 'demand' for a product or service before the supply chain management system is applied.

At the heart of this whole issue is the fact that treasurers, accountants, credit agencies and financial institutions like to be able to predict cash flow for at least the next twelve months and strive to ensure that it is robust and reliable. However recent events have shown that the world’s economy is at risk if organisations rely upon credit rating agencies that take only the basic working capital fundamentals into account.

Our research has identified that 'non recorded' processes amount to over 50% of a persons workload. This means that on a practical and quite basic level streamlining all internal working capital processes would generate substantial cost savings. There is an opportunity to rapidly and rationally assess the way your organisation works in the area of working capital optimisation and cash flow forecasting; an opportunity to ensure that core activities and processes are efficient and fit for purpose. Organisations that respond in this downturn will be the best placed to take full advantage of the inevitable cyclical change.