Working capital management is an intrinsic part of the CFO job description.
- Working capital management refers to a company's strategy related to monitoring and utilizing the two components of working capital—current assets and current liabilities—to ensure the most financially efficient operation of the company.
- The primary purpose of working capital optimization is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
- It is often one of the cheapest way to obtain cash for a company and adds value to all stakeholders, including shareholders, and should therefore be considered of strategic importance for the entire company, not just the finance function.
Accounts receivable management requires a concerted action plan by multiple teams.
- Make the finance team take ownership of clients and responsibility for decreasing outstanding accounts receivable, ideally tying a part of their compensation to this end.
- Finance and commercial departments must collaborate closely on this issue and work together to build a strong and positive relationship with clients.
- Billing processes should be analyzed, optimized, and preferably automated to make it as smooth and frictionless as possible for clients to pay outstanding bills.
Inventory is an extremely difficult working capital item to manage because it has important implications for the operations of a company.
- Finance and operations teams need to work together with aligned objectives set by upper management.
- Operations and finance usually have contrasting objectives when it comes to working capital. Operations departments tend to increase inventory levels to secure production and stock slow-moving articles, whereas finance departments look for reductions of inventory levels.
- An important challenge related to inventory management relates to slow-moving inventory. These are a source of hidden working capital losses and absorb warehouse space with maintenance costs.
- In industries where production and project-related contracts are over a long period of time inventory optimization includes a set of additional issues that are not present in industries with smaller products and where manufacturing is standardized.
Accounts payable is the third pillar of working capital optimization.
- If the company in question can re-negotiate payment terms with privileged suppliers, this is obviously an excellent path forward.
- An important action item related to accounts payable optimization would be the creation of a centralized department which should implement a standardized process for the treatment of invoices.
- it is important to enact efficient internal procedures related to any internal approvals that must be obtained in order for invoices to be paid.
- Reconciliation of payments made to suppliers and invoices paid ideally needs to be done the same day, if not made immediately.
Over my 25 years of professional experience as a CFO for companies in Europe and Latin America, I’ve encountered all sorts of issues related to financial management. But by far one of the most significant, and critical, for the financial health of a company is working capital management. Working capital management refers to a company’s strategy related to monitoring and utilizing the two components of working capital, current assets, and current liabilities to ensure the most financially efficient operation of the company. The primary purpose of working capital optimization is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
Working capital improvement is an intrinsic part of the CFO job description. Working capital optimization adds value to shareholders and is vital for the whole company, and thus should be the responsibility of the entire management team, not just the finance function. The finance team drives and leads the process, but the decisions made by the rest of the company should all share the common goal of optimizing working capital. Working capital optimization is also one of the cheapest ways a company has to obtain cash. Companies sometimes unnecessarily take on debt when cash that is idly stuck in working capital would be enough to finance new capital expenditure projects or to avoid useless overdraft costs.
This article intends to provide some practical tips and guidance related to working capital management and the working capital cycle as displayed above, based on my own experiences. It is not intended to be an exhaustive overview of the subject, but simply elucidates some important tips and focus points, with a particular focus on the industrial, oil and gas, telecommunication, consulting, and service sectors.
Accounts Receivable (Debtors)
In my career, I have seen cases of companies that, despite healthy underlying profitability, were pushed to the brink of bankruptcy purely because of poor working capital management. One such example was a large multinational car manufacturer. This company had a specific Brazilian subsidiary that had so poorly mismanaged their working capital position that they had reached over 200 days of accounts receivables. Our action plan in the first year was, therefore, laser-focused on two things: accounts receivable reduction and spare parts inventory reduction.
For the purpose of reducing accounts receivable, there were several major challenges. Firstly, some of the accounts were so old that they were practically unrecoverable. Moreover, being in Brazil, and accounts receivable being denominated in local currency, the depreciation of the exchange rate meant we were under strong pressure to recover the payments as quickly as possible. We, therefore, focused our attention on a few key action items aimed at tackling the situation as effectively and rapidly as possible.
The first thing we did was to create an ad hoc three-person finance team to focus exclusively on the issue of accounts receivable reduction. Each member of the team was in charge of a number of clients and introduced to each client as their relevant account manager. For a number of years, communication between the accounts receivable department of the Brazilian subsidiary and the accounts payable departments of the different car manufacturers had virtually broken down. Our new dedicated team worked closely with the commercial team in charge of each manufacturer so that joint visits to clients were made when needed. The CFO would receive a progress report every morning related to the payments received the day before and would meticulously follow up with the team on the various items of the action plan.
Another important action we took regarded education. An understanding of the payment process of each client is needed to make sure that invoices are presented correctly according to the internal procedures of the client, and that no time is wasted on back-and-forth related to amendment and corrections of invoices. We, therefore, undertook an analysis of our internal billing procedures to make sure that the company billed the client as soon as possible with zero mistakes.
We also worked heavily on improving and updating our internal payment application processes. One of the issues was that some received payments remained unapplied for a number of weeks, making it impossible to have reliable information when contacting clients for outstanding accounts receivable issues. An automation of the payment process was also implemented with those clients that still paid manually. While this automation can be time-consuming to enact, it should be viewed as an investment with the ROI of collecting accounts receivable on time. Exceptions to automatic payments were also analyzed and corrections to the billing procedures were taken into account to eradicate these exceptions going forward. The IT department was therefore actively involved in the daily follow-up meetings.
Finally, the focus on improving accounts receivable went all the way up to the CEO, who followed the entire project closely via weekly meetings with the CFO and the rest of the company’s leadership.
Lessons Learned as CFO
The results of our efforts were impressive. In the first year alone, we generated an extra $21 million in cash, purely based on the efforts outlined above. This should serve as an important example of how critical it is to focus on working capital management. In particular, here are some of the key takeaways I would call out:
- Make the finance team take ownership of clients. Delegate responsibility to individuals within the finance and commercial teams, and make them take ownership of the need to decrease outstanding accounts receivable. A part of the year-end bonus of the team we created was linked to the performance of the outstanding receivables under each manager’s purview.
- Make each member of the finance team responsible for their own action plan with each client, and each action plan needs to be tailored to the client’s internal payment procedures.
- As CFO, follow up daily on the progress of each action plan. Make sure that you, as CFO, understand how the payment process works for your main clients to make sure that you are respecting the payment procedures of the client and that these payments can be processed automatically with as few exceptions as possible.
- The entire management team of a company is responsible for working capital optimization. finance and commercial departments need to work together on this front.
- Create a close relationship with each client and visit them personally in extreme cases such as claims, if needed. Don’t make the mistake of thinking that clients will automatically pay.
- Analyze, improve, and automate billing procedures to bill clients fast and with no mistakes. Solve all billing exceptions, even small ones, as these exceptions can create larger outstanding accounts receivable in the future.
Inventory is an extremely difficult item of the working capital balance to manage as it has implications on the actual operations of the company. Finance and operations teams need to work together with aligned objectives set by upper management, something which doesn’t usually happen. Operations and finance usually have contrasting objectives when it comes to working capital. Operations departments tend to increase inventory levels to secure production and stock slow-moving articles in case these parts are needed in the future. Finance departments instead look for reductions of inventory levels.
An important challenge related to inventory management, in the context of working capital optimization, relates to slow- (or even non-) moving inventory. Slow-moving SKUs are a source of hidden working capital losses and absorb warehouse space with maintenance costs.
By way of example, I worked for two companies in Brazil and in Spain, again in the automotive sector. When I arrived, at least 10% of inventory were slow-moving items which were unidentified. Similarly, I also worked for two companies in the telecommunications sector, in Italy and in Spain. In Italy, the subsidiary had 30% of unidentified slow-moving articles, in Spain, the company had 25% of slow-moving articles. The audits we performed helped uncover these issues and remedy them, but a complete “cleaning” of inventory takes time and a joint effort from the finance and operations departments in the company. Companies would be better off tackling these issues up front.
The problem is exacerbated in sectors in which inventory is often held in consignment with suppliers. This is something particularly prevalent in industries such as the automotive sector. In the Brazilian company I mentioned above, consignment stocks were in 15 different locations. The issue with keeping stock in consignment is that you effectively also outsource the supervision of the inventory, making it even more likely that problems related to slow- and non- moving articles will arise.
In industries where production and project-related contracts are over a long period of time (such as real estate construction, railway, long-term consulting projects, etc.), inventory optimization includes a set of additional issues that are not present in industries with smaller products and where manufacturing is standardized. For instance, a common issue relates to the terms of payment, where the client’s services are often one of the most important components of overall costs, and play a key role in ensuring that the schedule of costs incurred is aligned with the schedule of milestones that in turn are invoiced to the client.
In my professional experience in the railway and construction industries in France and Italy, and in the consulting sector in Spain, I’ve encountered several issues related to the above. For instance, one of the most common problems has to do with matching costs with the right project. Similarly, billing timing is often misaligned with the actual completion of the project milestones. In my experience, the best way to tackle this issue is by delegating responsibility to a project manager whose variable compensation is tied to the performance of the project. The most successful performance indicator for a project manager is the cash ratio of the project, and consequently the extent to which the project is self-financed. If the cash in/cash out ratio is higher than 1, the project can be considered to be performing well (financially).
Having said this, project managers need to be equipped with effective tools to manage their projects. The accounting system needs to allow for segregation at a project level (i.e., project managers should receive project-specific reports where costs, revenues, collections, and payments are all specified on a project basis). Moreover, claims and litigations need to be monitored by the project manager, who should in turn act as the liaison with other departments such as legal, finance, and supply chain.
Lessons Learned as CFO
- Working capital optimization with respect to inventory is always a joint effort between finance and operations as inventory levels are intimately related to production.
- Slow- or non-moving items are sources of costs and losses in terms of tied-up capital and in maintenance/warehousing costs. Efforts to eliminate slow-moving articles are time-consuming and intensive, meaning that the issue should be dealt with proactively rather than reactively.
- In industries where inventory is managed by project, a correct matching of the costs and revenues with the right project is vital for the financial health of the company. Assigning responsibilities to project managers is the best way to manage this issue. Project managers need to be armed with the right software to follow their projects’ costs, revenues, payments, and collections.
Accounts Payable (Creditors)
Accounts payable is the third pillar of working capital optimization. The most obvious thing that usually comes to mind when thinking about ways to optimize accounts payable is simply increasing the payment terms with suppliers. If the company in question can re-negotiate payment terms with privileged suppliers, this is obviously an excellent path forward. However, there are other ways to increase accounts payable while keeping the payment terms unchanged.
For instance, an important action-item related to accounts payable optimization would be the creation of a centralized department which should implement a standardized process for the treatment of invoices. Invoices with mistakes in quantities, contact details or the number of purchase orders that the invoice relates to should be sent back to suppliers and requested to be corrected. Another useful thing to do is for the accounts payable team to send suppliers an official acknowledgment of receipt if an invoice is received electronically so that the terms of payment are considered as starting from the date of such acknowledgment.
Moreover, it is important to enact efficient internal procedures related to any internal approvals that must be obtained in order for invoices to be paid. Automation is key to avoid a useless and ineffective payment trail. Again, as we discussed earlier in the accounts receivable section, a proactive attitude and high level of communication between the accounts payable department and suppliers is key and allows claims and exceptions to be solved more efficiently. Accounts payable also needs to communicate effectively with the other departments of the company who approve payment of invoices, particularly since, in cases where legal issues arise, the accounts payable department is often not able to make decisions related to the resolution of such cases. Finally, the accounts payable department must be in close contact and collaboration with the warehouse of the company that receives the goods. Exceptions can be frequent if procedures are not standardized and automated.
Reconciliation of payments made to suppliers and invoices paid ideally needs to be done the same day, if not made immediately. It is important to have a clear picture of which invoices are due to each supplier in real time. This information is useful for the supplier and for the department using the goods or services delivered by the supplier. It is also important not to pay before the invoice’s due date unless there is a specific reason to do so. However, in a similar vein, it is also advisable to avoid significant payment delays beyond the due date, since this signals that the internal payment procedures of the company in question are not working as they should be.
Accounts payable must also always be up to date with the terms of the contractual agreements with each supplier. It is important to keep accounts payable informed of new contracts signed with suppliers, addenda to existing contracts, or new master service agreements. New contract conditions need to be updated in the master file of each supplier, and invoices arriving from suppliers need to be compliant with this master file. In the case of companies working on a project basis, the complexity of the contracts signed can be high. As soon as the contract is signed, it is useful for the department in charge to organize a presentation to the finance and accounts payable team so that future invoices can be easily understood and thus be paid in a timely manner. Also, in these complex contracts, it is important to have the related cash flow projections, since these often greatly affect the overall cash flow of the company.
Lessons Learned as CFO
- As always, communication between the finance department and other departments of the company is key to improving the workflow related to accounts payable.
- A solid understanding of contractual terms with suppliers is important so that invoices are treated correctly and also to ensure the correct segregation of duties. All the relevant contractual terms of invoices must be known by the commercial department, and these terms should be outlined clearly in a contract, a purchase order, or a master service agreement. Invoices need to be paid as per the agreed terms in the contract.
- Automation of accounts payable—from receipt of the invoice through the process of internal approval to the accounting treatment of the invoice and update of the supplier ledger—is key so that a clear picture of the supplier account is available in real time. This allows managers of all levels to make decisions related to the supplier account in an efficient and effective manner.
Working capital optimization is the cheapest way to free up cash in a company and in extreme cases reduce or eliminate long-term debt originated as a result of an excess of working capital. Optimizing working capital is an intrinsic part of a CFO role, who manages the finance team and drives the other departments of the company to increase cash. The finance organization monitors processes and works together with other departments in the company in the common goal of reducing working capital. Working capital varies with the different industries. The basic principles of collecting accounts receivable fast, with automatization of processes and joint collaboration of finance, IT, and commercial/project management teams remain common to all organizations. On the accounts payable side, supply chain teams/project managers, finance, and IT need to work together with the common goal of increasing accounts payable and reducing inventory.
Understanding the basics
What is working capital management and why is it important?
Working capital management refers to a company's strategy to monitor and utilize the two components of working capital: current assets and current liabilities. Its primary purpose is to ensure the company maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
What's included in working capital?
Working capital refers to liquid cash available for day to day operations and is calculated by subtracting current liabilities from current assets. Current assets includes cash, accounts receivables, and inventory. Current liabilities mainly includes accounts payable.
What is considered slow-moving inventory?
Slow-moving inventory are items that do not turn over in the warehouse within “normal” time frames (e.g., more than 90 or 180 days). These are a source of hidden working capital losses and absorb warehouse space with maintenance costs.