Businesses often fail to make the most of net working capital (NWC). Leadership teams tend to focus on the profit and loss (P&L) statement, frequently at the expense of the balance sheet. We see very few organizations managing their liquidity with the same rigor as they do their costs. However, expert management of the cash conversion cycle can rapidly free up liquidity while avoiding headcount reductions or an operational restructuring.
Efforts to optimize NWC face several obstacles. Leaders often have limited visibility into liquidity performance, P&L-focused financial reporting doesn’t adequately measure NWC metrics, and managers’ incentives are frequently misaligned with effective NWC management. Possibly the most significant challenge: Employees at all levels make daily business decisions that impact the cash conversion cycle, so any sustained improvement requires cross-functional cooperation and an organization-wide focus on cash.
A structured approach to NWC
Optimizing NWC requires a holistic approach, targeting accounts receivable, accounts payable and inventory processes. Companies that excel at NWC management leave no stone unturned in the search for improvement. Five steps can support this journey.
1. Recognize NWC as a source of value
Accounts receivable, accounts payable and inventory management are the vital foundations of the balance sheet, yet they are frequently managed as an afterthought compared with revenues and expenses. It’s understandable: Optimizing NWC is not a straightforward task. While many of the tools for improving NWC are well-known, implementing them effectively is difficult. Many organizations already have put into place measures to improve receivables, payables and inventory with limited success. There is no one-size-fits-all approach, and guidance on what can be achieved through best-practice benchmarks is often scarce and industry specific.
Despite these challenges, the benefits are well worth the effort. Better management of NWC preserves cash and can provide a critical lifeline in times of business distress. Leaders start embedding a cash mindset throughout the organization by including cash topics in executive and business unit reporting.
2. Understand the cash conversion cycle
It is important to understand details of the cash conversion cycle to determine how much liquidity is tied up in accounts receivable, accounts payable and inventory. Leaders following best practices provide visibility at the level of individual customers, vendors and SKUs, as averaging multiple transactions may obscure particular problem areas. Evaluate how core processes that influence NWC are running and assess whether the right disciplines are in place to provide oversight. This review will highlight the areas that are working well and those that need to be upgraded.
Collect information from multiple functions to understand the current state of cash conversion. Involve the commercial teams that manage receivables, the procurement teams that influence payables, and the operations and supply chain teams that oversee inventory, as well as business unit or channel leadership.
3. Identify areas of opportunity
A solid understanding of the existing cash situation allows companies to pinpoint potential NWC improvements. This step also requires cross-functional collaboration, given the many daily decisions that affect NWC. To lead this effort, assemble a team of individuals who have a track record and passion for leading change. Their task is to identify the “long-list” of opportunities. Some examples:
- Managing receivables. Instill rigor in collections management by improving the processes to monitor collections, track slippage and identify emerging trends. Feed this analysis back to operations to tailor customer engagements.
- Managing payables. Improve payment discipline by overhauling internal supplier payment processes. Improve the timing of supplier payments, lengthen supplier terms and use the most efficient payment methods.
- Managing inventory. Pursue reduction opportunities without compromising on service levels or risking stock outages. Identify and rationalize underperforming SKUs to focus on core products and simplify operations.
4. Prioritize areas of opportunity
Use the long-list of NWC opportunities to rank actions in order of priority, creating an initiative roadmap. The roadmap should support the company’s strategy and broader business priorities. Start with actions that can be implemented immediately to preserve liquidity, while designing more complex longer-term initiatives in parallel. When creating the roadmap, it’s helpful to organize NWC initiatives in three groups:
- Rapid, “no-regret” actions. These moves free up working capital and can be executed immediately without detailed justification. They may be a first step in a broader initiative or a specific action, such as eliminating early supplier payments.
- Discrete, quick-to-execute measures. This group includes actions that can be accomplished with minimal system or process changes. Their value is backed by targeted, high-level analysis such as the return on selling slow-moving inventory, not an in-depth appraisal.
- Complex initiatives that warrant careful consideration. These initiatives may be dependent on the execution of system or process changes. A detailed analysis can validate the opportunity and indicate when teams need to seek cross-functional alignment, such as in rationalizing product lines.
5. Launch NWC initiatives
Using the roadmap as a guide, assign clear ownership of initiatives, set up a governance structure to track and monitor progress, and launch the first wave of actions. Four elements will be instrumental to success:
- Engaged senior leaders. Ensure the NWC program is sponsored by senior leaders who can resolve delays, celebrate successes and act as cash role models.
- Clear initiative tracking. Use a dashboard with simple key performance indicators to make progress visible and keep leadership informed.
- Agile team principles. Embed Agile principles across your delivery teams to drive accountability and enable quick feedback cycles to facilitate fast-paced progress.
- Aligned incentives. Add NWC metrics to managers’ incentives to expand their focus beyond pure P&L outcomes.
NWC can provide lifeline amid Covid-19 disruption
Rigorous management of NWC can help companies weather the downturn brought on by the Covid-19 pandemic. While the recession may limit traditional external optimization options, such as renegotiating contract terms, internal actions can deliver significant value. These include improving collections management processes, initiating daily spending review sessions to challenge purchase requests, developing best-in-class procurement practices and adjusting inventory management. Such actions can improve cash management, helping companies navigate a sustained downturn and recover from the Covid-19 crisis in a stronger position.
Don’t leave cash on the table
Successful companies recognize the power of skilled cash management to strengthen the balance sheet. Improving the cash conversion cycle generates immediate liquidity to fund other transformative initiatives, increases enterprise value, improves credit rating and raises performance in the organization. Since the elements of NWC touch every part of a company’s operations, there are almost always opportunities to refine receivables, payables and inventory. However, there is no single recipe to optimize NWC. Leaders tailor their actions to their operating ecosystem and work to embed a cash culture. They know every day of operating with improved working capital can deliver significant rewards.