The Idea in Brief
- In the hard times we’re experiencing, companies are scrambling for cash. Fortunately, many have a lot locked up in their operations because the recently ended boom encouraged sloppy working-capital management.
- Companies typically make some or all of six common mistakes in managing working capital: they manage to the bottom line; they reward the sales force only for growth; they overemphasize production quality; they link receivables to payables; they manage to current and quick ratios; and they benchmark competitors’ practices.
- Simply correcting those mistakes will release a lot of cash. Longer term, though, companies need to create a culture in which everyone takes responsibility for the balance sheet.
The Idea in Practice
The six “don’ts” of working-capital management:
1. Don’t manage to the income statement. Many important cost items don’t appear on the income statement, which often encourages managers to tie capital up in stock and receivables. Example:
One metals refining firm reduced its level of receivables from 185 days to 45 days. This caused a fall in sales but allowed the company to save $8 million a year in reduced capital costs, which more than compensated for the lower operating profit.
2. Don’t reward the sales force for growth alone. When salespeople are rewarded only for booked sales, they have no incentive to help you manage customer payments. Example:
At the same metals refining firm, the sales staff was directed to help manage receivables. The percentage of overdue or bad receivables fell from 12% to less than 0.5% of the total, generating annual cash flow of nearly $3 million.
3. Don’t overemphasize production quality. Rewarding production people primarily on quality metrics encourages them to gold-plate and slow down production. Example:
One European producer of drive systems for power generation had a manufacturing cycle nearly three times longer than those of its competitors, but the company was unable to pass associated costs along to customers. By scaling back on non-value-added quality, the firm reduced cycle times and cut inventory by 20 days, freeing up €20 million in capital.
4. Don’t tie receivables to payables. The power balance in your supplier relationships may be very different from that of your customer relationships. Example:
When a French small-appliance manufacturer introduced different terms of trade for each of its supplier and customer segments, it freed up capital of around €35 million, for a business with annual revenues of less than €450 million.
5. Don’t manage by current and quick ratios. Bankers use current and quick ratios in making credit decisions, and many companies consequently try to maximize those numbers. Example:
A French consumer goods company proudly announced that its current ratio had risen from 110% to 200% and its quick ratio from 35% to 100%. The company declared insolvency six months later.
6. Don’t benchmark competitors. Managers become complacent when their working-capital metrics are in line with industry norms. Example:
It was only when Michael Dell compared Dell Computer’s working-capital management with retailers’ rather than with other computer companies’ that he realized what his company could potentially achieve.
The boom years made businesses careless with working capital. So much cash was sloshing around the system that managers saw little point in worrying about how to wring more of it out, especially if doing so might dent reported profits and sales growth. But today capital and credit have dried up, customers are tightening belts, and suppliers aren’t tolerating late payments. Cash is king again.
