17 June 2016

Adopting Working Capital 2.0 for a New Growth Strategy

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The working capital strategy that saw your company through the financial crisis may now negatively impact your chances of benefiting from the economic growth that is gradually reappearing. That's why adjusting your strategy may be critical for enhancing your working capital position while also improving the resilience of your supply and sales ecosystems.

The numbers may not exactly be breath taking, but there are clear signs that mature economies, sluggish in the wake of 2008, are starting to recover. According to the US Commerce Department1, the country's economy grew at a 2.0% annual rate in the third quarter of 2015. The global picture also appears to be picking up, with the IMF predicting global growth will hit 3.4 per cent in 2016, versus 3.1 per cent in 20152.

Moving on from post-crisis survival mode

While this growth is encouraging, it may perversely trigger a series of failures in corporate supply and sales ecosystems. In recent years, due to the financial crisis, most companies have focused on working capital largely in the context of survival. With this, many treasuries adopted a strategy of extending days payable outstanding (DPO) and compressing days sales outstanding (DSO). Those that did may have ensured the survival of their organisation, but likely not without negative consequences elsewhere. Every company operates within a highly interlinked commercial ecosystem, so every day a buyer extends its DPO it causes an extension of a supplier's DSO.

The potential (and illogical) negative impact of growth

One might reasonably assume that economic growth would improve these effects. However, due to the bullwhip effect3 that growth triggers in supply and sales ecosystems, the reverse can often be true. As demand increases, purchasers place larger orders with suppliers, but to fund the fulfilment of those orders suppliers require additional working capital. If the working capital strategies of others with greater commercial leverage in their ecosystem do not change, then they will be unable expand their working capital capacity. A similar situation applies to distributors experiencing higher customer demand that are unable to fund the necessary stock levels. The resulting irony in both cases is that these companies can effectively `grow' themselves into another crisis.

Evolving economic times call for a shift in strategy

Many larger organisations seem unaware of the operational risks they are facing in the possible insolvency of key suppliers and distributors as economic activity picks up. In an ideal world, companies with the most commercial leverage would relax their DPO/DSO targets, to enable smaller suppliers and customers to meet rising demand effectively. However, given the importance of working capital as a key performance indicator, that is unlikely to happen.

In which case, what is the remedy? If working capital is not to be redistributed directly among existing ecosystem participants, an external source is clearly needed. Furthermore, that source must be of minimal cost or it will ultimately be reflected in higher costs of goods sold (COGS). Therefore, rather than capital markets solutions such as bond issuance, some form of trade financing solution - where reduced pricing reflects the lower risk of trade relationships and the self-amortising nature of transactions - may be preferable.

Implementing the right Working Capital 2.0 strategy...

It would be easy to assume that supply chain financing is the obvious remedy here, but that is not the case. For instance, if a company is in the process of centralising its enterprise resource planning (ERP) system, the additional burden on its IT organisation of implementing a supply chain financing program would be ill-advised. Other solutions, such as assisting key trading partners to use receivables finance would be an interim solution, with supply chain financing as perhaps a better option post ERP centralisation. Other tools from the working capital toolbox including forfaiting, reverse factoring, guarantees or letter of credit might also be appropriate.

The critical point is that while some form of action is definitely needed now to accommodate the growth phase working capital needs, there is no single perfect universal solution. Each scenario requires analysis, ideally by a banking partner that is involved at all levels of global trade and that has an intimate understanding of the working capital needs of participants of all sizes and industries. Only then can the optimal working capital injection method for a specific ecosystem situation - including both suppliers and customers - be provided.

...and monitoring effectiveness with the right metric

This isn't a static scenario. At present we appear to be moving from a five-year period of low/no growth to a gradual growth environment. However, this could change again in due course in either direction, which makes simply thinking of working capital as a one-off event unwise. Instead, a three of four year rolling strategy for working capital that is also flexible enough to accommodate interim economic change would be more appropriate. The current emerging market situation is a good example of almost overnight changes that make such flexibility essential.

This more dynamic approach requires a suitable metric for measuring working capital performance both internally and externally. Current ratios or asset test ratios are popular in many organisations as a means of measuring cash liquidity position, but they do not take into account an important factor: time. By contrast, the cash conversion cycle Defined here as DIO (days inventory outstanding) + DSO - DPO is a better metric for changing conditions and also for determining the most appropriate working capital strategy for the future that will allow a company and its suppliers and buyers to grow together.

Conclusion

The headline message here is that working capital strategies that suited the aftermath of the financial crisis need revising. Otherwise there is risk of economic growth actually reducing net economic benefit at a corporate level. Addressing this point now will allow you to avoid this scenario, as well as optimising your working capital, plus that of your suppliers/buyers.

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