When cash is abundant, interest rates are low, and borrowing is easy, optimization of working capital is often seen as a low priority. But raising free cash flow is now a top priority for the CFO’s office, as companies find their cash locked up in inventory, payables, and receivables. We’re still reeling from the effects of a global pandemic and all the inventory and supply chain challenges that entailed, shifting consumer spending patterns, an economy teetering on the brink of recession, and high interest rates that have dramatically changed corporations’ attitude toward borrowing. The balance has shifted, and growth is more dependent on having sufficient free cash flow than the availability of low-cost financing.
The optimization, maximization, or overall improvement of available working capital would seem to be mere table stakes in any management strategy. Unusual circumstances call for a more holistic approach that goes beyond the traditional linear methods often applied to capital management, and the CFO is particularly well-placed to see the entire end-to-end working capital picture and take decisive steps to improve it. Long-term success and continued growth require a balance of three pillars: release cash, reduce cost, and improve service.
Why Is Optimization Important?
Total working capital, reflected in the combination of payables, receivables, and inventories, does more than just reflect availability of cash. Optimization of that working capital will also reduce costs and improve services. It can also meet multiple strategic goals, including increasing shareholder value; enabling mergers and acquisitions funding, debt reduction, and share buybacks; improving profitability; funding internal projects; and facilitating growth and investment.
During 2023, we continue to see the impact of COVID-19, permanent changes in supply chain strategies, higher interest rates with an unpredictable federal policy, and a real possibility of recession. A company may be otherwise performing well, but other factors are minimizing the amount of available cash that could be used for dividends, growth, and expansion.
Without a new approach, current events could well lead to a crisis. Regardless of the merit of any organization’s product line, it can’t survive without liquidity. It’s incumbent on the CFO to ensure that the right processes are in place and that cash is readily available—if not through financing then through other methods of working capital optimization. Fortunately, with the right strategies and tools, that optimization can be easily achieved, and cash can be made available when it’s needed.
Three Pillars of Working Capital Optimization
Those tools begin with a set of three pillars: release cash, reduce cost, and improve service. A company’s successful cash mentality is never a one-size-fits-all approach, and those who limit their cash strategy to one area alone, such as maximizing receivables or cutting costs, will never be able to achieve their full cash potential.
Going beyond the mainstream linear approach to capital optimization, Total Value Optimization (TVO)—a management methodology that takes into account the entire end-to-end supply chain and is endorsed by the University of Tennessee’s Global Supply Chain Institute—incorporates all three of those pillars. By doing so, these changes can yield a measurable benefit over a short period of time that will allow companies to have improved free cash flow and to better position themselves for growth.
The results of employing the TVO approach can be positive across several areas of the organization, with optimization of inventory like stock keeping unit (SKU) product range management, inventory management, forecasting and planning, sales order processing, materials scheduling, manufacturing execution, and warehousing and distribution.
Using the TVO methodology, a large manufacturer of solar control and safety window film implemented a high-velocity demand-pull process and sales and operations planning process that yielded an $11 million improvement in EBITDA (earnings before interest, taxes, depreciation, and amortization) and an $18 million decrease in working capital requirement. In another example, implementation of a sales, inventory, operations, and planning (SIOP) process reduced a company’s inventory position by $15 million, which allowed the company to reinvest in technology and maintain its share of a very competitive market.
On Poor Working Capital Performance
Some macroeconomic issues such as interest rates, pandemic-induced supply chain stresses, and the possibility of recession may be beyond the finance office’s control. By focusing on what can be controlled, it’s possible to achieve a positive outcome and gain control of working capital even in the face of these issues.
Several inventory-related factors can contribute to poor working capital performance, potentially leading to a competitive disadvantage, lower profitability, reduced cash flow, and poor supplier relationships. With a strategic approach and the correct tools, all these issues can be remedied in any economic climate. When these inventory issues are addressed, working capital improvements can be quickly achieved.
Some of these inventory-related issues include:
- Distribution: Addressing issues such as a high level of stock crossovers, poor picking accuracy, and a high level of damaged or returned product will quickly return locked capital to the organization.
- Supply chain strategy: Improving oversights such as a lack of strategy, not considering the impact of working capital on supply chain, and not considering customer/supplier constraints will help to improve visibility and more easily address those working capital challenges.
- Product management: Product issues impacting working capital include an unknown product profitability level, a proliferation of product range, and product cannibalization.
- Forecasting: Working capital may be negatively impacted through inaccurate sales forecasting, poor accountability for accuracy of the forecast, and a forecast that isn’t granular enough to impact inventory management.
- Sales order processing: Working capital may be negatively impacted through lost sales not being recorded, agreeing to unrealistic delivery parameters, and frequent changes in customer requirements.
- Production scheduling: Other issues to consider may include poor data integrity in product scheduling, including bills of material, lead times, inventory levels, and poor visibility.
- Raw material planning: Poor vendor reliability may also negatively impact cash flow, along with short notice of material requirements or inefficient raw materials receiving processes.
- Production planning: Issues in production planning may include a mismatch between capacity and product mix, a mismatch between order and minimum batch quantity, and poor communication with purchasing.
- Production: Production bottlenecks and poor order prioritization may be major factors in working capital performance, along with frequent or long changeovers, ineffective replanning for delays, and excessive or nonscientific buffers.
- Warehousing and inventory management: A high level of slow-moving or obsolete stock can be a significant issue in working capital, along with duplication of safety stocks and poor correlation between stock levels and customer service.
Solution and Benefits
Management must go beyond traditional linear tactics to balance optimization across three areas: payables, receivables, and inventory. Traditional drivers of payables and receivables would include tried-and-true tactics of renegotiating payment terms and offering favorable terms for clients to pay earlier. Receivables optimization may also include tactics such as reducing the quantity of potential disputes and monitoring the dispute cycle. On the payables front, taking advantage of price discount captures may also lead to some freeing of cash and lowering of potential debt interest.
Beyond payables and receivables, inventory issues are often at the root of the working capital crisis, and many companies are now seeing a whiplash effect. Companies found themselves with excess inventory, shifting sales trends, and cash being tied up in that inventory. This also led to degraded service quality, as products that customers want may no longer be available, prices will have to increase for those that are, and cutting one area too sharply could negatively impact service levels.
Reducing SKUs and product range may be seen as a short-term solution, but it also may negatively impact service. Early pay discounting may have an apparent negative impact on working capital, but doing so may also have a positive impact in other areas and drive a shorter-term boost to the profit and loss statement. Other short-term receivables tactics like factoring may also bring in working capital more quickly but could also bring higher costs later on.
Aligning sales with inventory will deliver a more accurate and predictable picture and better cash management—along with improvements in service to the customer. Using SIOP accomplishes that alignment using tactics like automation and analytics to better align the silos of sales, production, manufacturing, assembly, and logistics. The result is delivering the product as fast as possible and at the highest value, with better service to the customer.
An end-to-end solution extends from initiatives addressing raw materials, work in progress, semi-finished goods, and finished goods, with enhanced visibility in inventory at every stage of the product life cycle. Opportunities for improving cash flow and optimizing working capital are present at every step. In the raw materials phase, improving working capital may begin with segmentation by value and usage, rescheduling of suppliers, and more on-time delivery. Once work is in progress, further improvements can be gained through lead-time reduction, by outsourcing production overloads, and in the semi-finished goods arena. Improvements can also be made with order quantity reduction and better planning synchronization. Finally, regarding finished goods, a root-cause analysis should look at the reasons for nonshipments, along with a weekly follow-up that identifies actions being taken to resolve all current and future delivery problems.
Other key initiatives include inventory management solutions that set targets, review and update policies on a regular basis, and define inventory strategy for each material type and at each location. In addition, linking sales order processing with production planning may also deliver improvements, as will improved materials scheduling that defines guidelines for replenishing materials based on a coherent inventory strategy. Finally, in the critical warehousing and distribution area, improvements can be made in defining where and how much material to hold while setting up an improved warehouse flow.
How Can the CFO Optimize Working Capital?
Getting started doesn’t have to be difficult, and the next steps on the optimization road map and improving the organization’s financial well-being begin with analyzing the current working capital position, identifying weaknesses and opportunities for improvement, and setting some clear objectives. The CFO’s office never works in isolation, and bringing in other departments that are affected by working capital will help in creating these objectives and identifying a clear set of policies and procedures—which may relate to issues around inventory, payables and receivables, and contract management. With new strategies and policies firmly in place, the cash forecast can be continuously revisited, with an eye toward gaming out multiple scenarios to identify the best possible solution as well as optionality and alternative plans.
Working capital optimization is a continuously improved process, never a one-and-done. Regular monitoring of key performance indicators (KPIs) and results will help keep optimization on track and help the organization make adjustments along the way should external circumstances change and demand a shift in approach.
Automation, Digitalization, and Analytics
Optimization will be built on a tool set that includes automation, digitalization, and predictive analytics, which may necessitate that the CFO’s office expand beyond traditional tactics and strategies to set the stage for a successful transformation of the digital supply chain. By implementing automation throughout the process, from analysis to execution, the company can reduce the cost and increase the accuracy of repetitive tasks. This automation may even be projected into the next level of actual management practices. For example, in inventory management, automation can be successfully applied in some areas of decision making, such as classification of inventory or where it should be located.
In the analysis phase, automation can be applied, for example, to deliver a continuous refresh of segmentation analysis to show inventory positions on a regular basis, taking key decisions by segment and embedding that into the system on an automated basis. Automation can also include a trigger that requires human intervention for things like exceptions.
Also, the staff shortages that have plagued warehouses over the past few years can be mitigated with technologies like barcode scanning and robotics along with software automation for decision making and repetitive tasks.
Who Needs Working Capital Optimization?
A call for optimizing working capital doesn’t necessarily mean that a company is failing or even at risk of failing. There are two distinct and separate needs—to be sure, some companies are ill-prepared, didn’t consider the future during the times of plenty, and are facing dire circumstances now. Even those companies can still benefit from optimization practices, implementing the three levers, and deploying a TVO strategy.
Companies not facing immediate risk will still benefit by better positioning their operations and cash flow to better meet current and future challenges. Companies may remain successful but may begin to realize that their cash isn’t moving as fast as it used to and may not be able to accomplish some of the more aggressive strategies that they would’ve considered when interest rates were at near-zero. Optimizing working capital will allow those companies to continue succeeding, stay on their growth path, and meet their goals more effectively while continuing to enjoy access to the cash they need to meet those goals. And, more importantly, the path to optimization of working capital isn’t, and shouldn’t be, a one-time cash release but a systematic, ongoing improvement of cash flow.
This approach of balancing the triple impact of releasing cash, reducing cost, and improving service levels, as compared to the traditional, linear approach more often undertaken to manage working capital, unlocks cash that would otherwise be tied up in inventory, payables, and receivables. The resulting cash culture enables a company to better withstand periods of slow growth or unexpected challenges while also providing much better visibility and control over inventory, receivables, and payables.