Reducing Working Capital

The Obsession with Working Capital: Unlocking Hidden Cash 

Reducing working capital is close to an obsession for CFO’s and other business managers – and rightly so. For achieving this can seem like creating ‘free money’; cash conjured out of thin air, either reducing debt and the costs of financing it or enabling increased investment in other money-making projects. 

Working capital is the total of the capital – i.e. cash – tied up in the business of doing business; The elements are: 

• Credit obtained in buying materials and services (Accounts Payable “AP”) 

• Finished goods or work-in-progress sitting on the balance sheet (Inventory) 

• Credit granted to customers (Accounts Receivable “AR”) 

This article deals with the pure cash elements of working capital: AR and AP; we’ll save inventory for another time. It stands to reason that the total of all the AR in the world at any one time equates to the total of all AP – every account receivable is someone else’s account payable. But alas, not all businesses are born equal and as often happens in life, the big guys stick it to the little guys. A Fortune-100 company may have the power to impose 30 days payment terms on all its customers and 75 days payment terms on all its suppliers, but a $100m business is on the other end of that equation. And none of the CFO’s are every fully satisfied. 

This article outlines a practical, three-step approach to identifying, prioritizing, and recovering working capital leakages – achieving measurable improvements in treasury management.   

Step One: Gain Visibility and Identify Working Capital Leakage from Contract terms. 

All organisations have policies, or standard terms, for AP and AR, but in practice things aren’t so simple. Sometimes, either due to an imbalance in economic power between the two sides, or where there is great competition for resources, suppliers or customers can impose their own terms. Often, though, the problem is simply ‘rogue’ buying or selling; staff deviating from company policy for whatever reason.  

Once Digital Mirror has ingested the customer and supplier contracts, it can rapidly identify and prioritize the sources of working capital leakage arising from contract shortcomings. 

Key Activities 

• Identify payment terms in all contracts 

• Process company policies on payment terms for customers and suppliers (by category if necessary) 

• Check the volume of business attached to each customer and supplier. 

Outcomes 

• The contractual working capital leakage attached to every customer and supplier 

Step Two: Gain Visibility and Identify Working Capital Leakage from Contract Performance. 

Here, we surface the working capital leakage arising from the failure of our customers to deliver on their contractually obligated payment terms, and our own failures in respecting our obligations to pay suppliers on time. There may also leakage from paying suppliers in advance of the due date. 

Key Activities 

• Analyse AP/AR/GL data to reveal the actual performance against contractual payment terms 

• Check the volume of business attached to each customer and supplier. 

Outcomes 

• The working capital leakage arising from contract performance attached to every customer and supplier 

Step Three: Prioritization and Value Recovery 

The results from Steps One and Two are combined to provide a full picture of the working capital leakage from every customer and supplier, and where it arises (contract terms versus performance) 

This done, the organization can start prioritizing areas with the highest financial and operational impact, prompted by insights from Digital Mirror. 

Key Activities 

• Summarise and rank main opportunities 

• Cross reference with contract renewal dates and contractual termination terms 

• Capture the team’s “tribal knowledge” within the prioritization process. 

Outcomes 

• A structured action plan for recovering working capital leakages with timelines, responsibilities, and measurable success metrics. 

Conclusion 

Once the sources of working capital leakage are identified, the real work can begin; AP and AR teams can be re-tasked with improvement plans, now the data is available. Contracts can be renegotiated with late payment penalties (the stick) or early payment discounts (the carrot), or prices renegotiated.  

But most companies are flying blind; they know they have a problem, but they don’t have the data and they don’t know where to start. 

It’s a well-known fact that companies fail more often from cashflow issues than from business losses. Eliminating working capital leakages is a critical first step to securing the future health of your business.