A new survey by REL, a division of The Hackett Group, Inc., suggests that companies are ignoring significant opportunities for optimizing working capital, especially when it comes to collections, payables and inventory management.
The numbers aren't encouraging. Examining the performance of 1,000 of the largest U.S. public companies, Hackett found that corporate debt was up 9.3 percent in 2015, to $413bn. It was the seventh straight year of rising debt levels, boosting companies’ total debt position by more than 58 percent since 2009.
The obvious driver behind the trend is stubbornly low interest rates, which act as a disincentive for any real effort to optimize working capital. Instead, companies prefer to borrow while it's still cheap to do so. Some of the money has been used for share buybacks, dividend payments and corporate acquisitions. Some is just sitting in the bank.
With the Federal Reserve slow to raise interest rates, companies gain access to "a very easy source of cash generation that requires minimal effort in making your day-to-day business better," says Hackett Group director Derrick Steiner. In his opinion, that's a short-sighted strategy.
The dilemma is just one symptom of a larger condition, whereby companies have been sitting on mountains of cash since the Great Recession. It's as if they're still feeling the trauma of the economic downturn, and are terrified of being caught without adequate funds.
But full coffers don't necessarily signal strong financial performance. Far from it, according to Steiner. He notes that the cash conversion cycle (CCC) – measuring companies' ability to turn spending on overhead, raw materials and labor into cash – has deteriorated by 7 percent, or 2.4 days. It now stands at 35.6 days, the worst since the 2008 financial crisis.
A major contributor to that dismal picture is low oil prices. An excess of supply has resulted in a sharp uptick in oil and gas inventories, acting as a drag on balance sheets, notes Steiner. (Oil and gas companies make up nearly 10 percent of the companies surveyed by revenue. In that industry alone, the CCC worsened by nearly 170 percent in 2015, expanding from four to 11 days.)
In all the industries surveyed, declining performance was evident across the board. Inventory performance was the biggest contributor to working capital deterioration, with days inventory outstanding rising in excess of 10 percent to more than 49 days. Days sales outstanding (collections), meanwhile, worsened by 1.1 percent, while days payable outstanding (payables) improved by over 5 percent.
Cheap as money is today, there's an even better source of liquidity available to businesses: the optimization of internal processes. According to Hackett, companies in the survey have the opportunity to improve working capital by more than $1tr, or 6 percent of U.S. GDP, based on the performance of the top quartile of performers in each industry. The figure breaks out into $421bn in inventory, $316bn in receivables and $334bn in payables.
They have a lot of catching up to do. Top performers convert working capital into cash seven times faster than laggards, Hackett notes. They collect from customers more than two weeks faster, pay suppliers more than two weeks slower, and hold less than half the amount of inventory. But only about 200 companies in the survey achieved that level of performance.
So how can the rest of the pack match the record of industry leaders? Start with understanding your own performance, says Steiner. "Anybody can calculate that from a balance sheet and income statement." Next, work to understand the norms within your industry, to assess how well your peers are doing.
After what Steiner calls "this high-level gut check," companies should dig deeply into the organization to understand the root cause of any deficiencies. Only then can they begin to develop appropriate metrics at the operational level, and begin taking corrective action.
On the payables side, companies should think beyond days payable outstanding to encompass "the end-to-end procure-to-pay cycle," Steiner says. What happens within one discrete corporate function affects all others. Finance, for example, is responsible for DPO, but one of the main drivers behind that measurement is payment terms, which are controlled by procurement. Traditional corporate silos need to work together to optimize the entire cycle, not just individual benchmarks.
Steiner also points to the benefits of supply-chain finance, where intermediaries work to get suppliers paid more quickly while allowing buyers to hang on to their cash for longer periods of time. Of particular value is the practice of dynamic discounting, which sets up a sliding scale of discounts based on the payment period.
In any case, Steiner says, "you want to make sure that invoices are processed through the cycle in a quick and efficient manner." Tools such as electronic data interchange, e-invoicing, supplier portals and up-to-date information technology can help.
With everyone in the organization marching in lockstep, procurement can set payment terms appropriately, backed by market intelligence, Steiner says. Any such action, however, requires a delicate compromise between the needs of buyer and supplier. Egregiously stretched-out payment terms can jeopardize the stability of key suppliers. Buyers should examine suppliers’ balance sheets and income statements to determine the latter’s DSO, then set appropriate payment terms based on market norms.
With the globalization of supply chains, inventory optimization has become increasingly tough to achieve. Companies are liable to find themselves burdened by pockets of inventory and little visibility across multiple locations. What's more, inventory levels tend to grow with the need for buffer stock, in anticipation of glitches in complex networks.
To address the inventory problem, companies need to share forecasts throughout the organization, tying them back to sales and operations planning (S&OP). In addition, they should practice customer segmentation, using statistical modeling and pre-determined service levels to set appropriate inventory levels for each account.
It's no easy task, but the need for optimizing working capital will only grow more pressing as interest rates begin to rise, and debt no longer is a viable option. Even today, though, short-changing the financial supply chain is no solution to long-term profitability.