You have got cash. Know how to free it up.
By following a systematic approach companies can free up cash and reduce working capital requirements.
- Article |
- 01 December, 2010
- Managers are aware that extra cash may be tied up in inventory and receivables; yet they are not able to free it up.
- By adopting a systematic approach, exercising more discipline and providing right incentives, they can free up extra cash and reduce their working capital requirements.
In a growing economy sales become more important than managing cash well. As a result, many businesses need more cash than required to run their operations. It is easy to get more credit in good times but securing more working capital during an economic crisis is not so easy.
The recent financial crisis has made businesses introspect and take drastic actions to keep the wheels rolling. Managers have learnt that cash is king during recession. However, cash always needs to be managed well - in good times and bad.
It is not uncommon to hear that cash is locked up in inventory and account receivables. But, without looking for ‘cash sinks’ in their business, managers try to make up for the shortfall by additional finance from banks or other sources. They also often end up delaying payments to their suppliers.
This article presents the reasons why businesses find themselves in a cash crunch and what steps they can take to improve their situation.
Looking for cash culprits
Getting to the root of the problem is an important first step towards improving the cash situation. Lack of discipline, wrong performance metrics, system gaps and even a tendency to avoid bold decisions can lead to more cash tied up in inventory and receivables. We look at some common cash culprits in turn.
Gaps in demand forecasting
Effective demand forecasting plays an important role in better inventory management. While stock-outs may risk losing sales, excess stocks build up inventory blocking cash in turn. There are many instances when demand forecasting is done at product line level but gaps emerge at product level or SKU (Stock Keeping Unit) level. This becomes more pronounced in case of products which have a very long manufacturing cycle time.
For new products, managers struggle to find the right benchmarks to forecast demand. This, coupled with their overoptimism for new products results in excess stocks in many cases.
Even if demand forecasting is accurate, we often observe that material procurement and production planning are not seamlessly linked with future anticipated demand (in spite of sophisticated Enterprise Resource Planning systems), resulting in excess procurement of raw materials or more work in process inventory.
Listed companies are under constant pressure to post better results. Even companies which have borrowed from banks face such pressures. In some cases, these pressures could be perceived, rather than actual.
Under such a scenario, managers have a tendency to put pressure on channel partners to lift off the finished goods even if there is no real demand. Sometimes, channel partners may themselves lift the goods if they have incentives linked to sales volume but not to collections from the customers.
By booking ‘artificial’ sales, managers are able to show higher sales and profit for their company. However, they end up deteriorating the cash situation. This may not be a big problem in good times but when the going gets tough, a huge amount of cash gets stuck in stocks in the name of receivables from channel partners.
Loose control on receivables
Companies lag behind in monitoring and following up on their receivables. Sometimes, sales staff shy away from following up for overdue receivables. The hesitation is based on a premise that the customers may run away to the competitors. This hesitation is uncalled for. Managers need to ask themselves - if there is a delay in delivering products to a customer, will she hesitate to call and ask for delivery? Then, why should one hesitate to follow-up for a delay in payment?
In many companies, there are delays in sending invoices and related documents to customers. This type of slippage can be used as an excuse for delay in payment by customers.
It is also not uncommon to find customers holding payments because a supplier has not resolved their complaint. Managers procrastinate to settle the claims to avoid a charge to the P&L account - as a result of either return of goods or a compensation to the customer - because it may reflect in their performance measurement. Customers enjoy the benefits of this procrastination, sometimes even avoiding payment of bills which have no relationship with the bills under dispute.
Ineffective credit policy
When a company intends to sell its products on credit, it determines credit limits for customers based on likely sales to the prospective customer, expected credit period and the customer’s risk profile.
Credit limits are, however, rarely reviewed on a periodic basis. Initial credit limits may become inappropriate after reviewing a customer’s buying and payment behaviour over a period e. g. the customer may not buy the goods as thought initially. Similarly, some customers may not be making payments as agreed but may still be receiving goods based on initially set credit limits.
It is also seen that initial credit limits are not changed in the hope of a customer placing a bigger order in the future. All of this adds up to giving more credit to risky customers who may take it for granted.
Generally, custom products are manufactured based on confirmed orders. However, sometimes managers initiate material procurement and other planning activities without actually receiving the confirmed order. In such a case, if the customer changes her mind, either canceling the order or changing the specifications, these goods will end up as non-moving inventory.
One machine tools manufacturer developed and manufactured final product without receiving complete specifications from a large customer. As the business environment changed drastically during this period, the customer began using variation in specifications as a delaying tactic to take deliveries. This created cash flow problems for the company putting the entire business in jeopardy.
Even worse, is that such custom products are kept in stock in hope of an order for a similar product in the future. However, this may not happen for months or sometimes years as seen during our work with a consumer durables company. Not many managers are willing to take a bold decision to dispose of such items because of non-realisation of full value, even if they are aware that the situation would not improve by their delay.
Lack of clarity in communication
Order management is a cross functional activity which requires effective coordination of various departments to deliver the right product to the customer at the right time. Given the complexity of today’s business operations and geographically dispersed teams, customer requirements may not be communicated well to planning and production departments, leading to wrong procurement of materials or mistakes in final products which customers refuse to accept.
The road to recovering cash
Once the root cause analysis is done to uncover the real reasons behind the requirement for extra cash, the next step is to find ways to free up cash from operations.
The road to recovering cash is long and arduous but a systematic approach, consistent efforts, and the right performance metrics can make all the difference.
Improve demand forecasting
Forecasting is not a perfect science but its accuracy can be improved over a period of time. It is possible to first start with a basic model based on historic sales and inputs from frontline sales staff. By accounting for various factors which can impact demand in the forecast model, a demand plan with a confidence level of 85% to 90% can be generated.
Rolling forecasts can further improve the predictive accuracy of a forecasting model. Marketing teams can develop demand forecasts on a monthly basis, providing estimated product-wise sales in quantity for the following month and probable sales for the next two months. The numbers can then be revised every month as better market information becomes available.
Where the number of SKUs is very large and the demand is not uniform across SKUs, it makes more sense to engage in SKU-level forecasting. Though it may be a cumbersome and time taking exercise, it is worth the effort. Moreover, with the availability of today’s Information technology, the process can be made much simpler and faster.
Demand forecasting should form the basis for the production planning and material procurement plan. This will help in achieving a lower level of inventory and thereby, avoiding unnecessary stocks. The whole process will bring more accountability in all departments concerned with order management.
Keep a tab on receivables
Receivables can hold a lot of cash if left unnoticed. To remind customers managers can send prompts to them a week before the due date. Further, continuous follow-up needs to be done if the bill is not paid on the due date.
A segmented approach to receivables can generate valuable insights. Receivables can be classified as bills not yet overdue, overdue and non-moving. The criteria for classifying a receivable as non-moving can be decided based on the credit term and the nature of the industry e.g. any receivables overdue over three or six months can be considered as non-moving receivables.
Next, a detailed analysis of each non-moving receivable should be done along with the account manager. If there is a dispute for any receivable, managers should resolve it quickly to convert the outstanding into cash.
When receivables are difficult to recover, it may be possible to recover the goods from the customer if the goods are in perfect condition. Taking back the goods will result in reversal of sales and profit booked earlier but it is better than not recovering at all. The company may have to sell such returned items at a discount if the goods are sensitive to change in seasons (either climatic or festive seasons). Even then, it makes more sense to convert such a receivable into cash rather than keep it as an irrecoverable amount.
Finally, if the overdue outstanding is very high and if it looks impossible to recover the amount in the ordinary course of business, managers may have to recover it through legal means. This action may also help in sending out a message to other customers who may require a similar approach. Of course, taking legal recourse should be the last option after weighing the value of the customer in the long run, the costs of litigation and the value recoverable.
Develop a robust credit policy
Prevention is always better than cure. For supplying goods on credit, companies need to develop and implement a robust credit policy. The credit manager can assess the credibility of a prospective customer, their expected sales value, credit terms and the risk which the company may be willing to take.
The credit policy should require strict adherence to the credit limits while despatching goods. It needs to have a built-in system to review the credit limit while booking orders. If the credit limit is likely to get exhausted with a new order, it should be communicated to the customer to either make the payment before delivery or to at least take an assurance that payment will be made on delivery.
The credit policy should also have a provision for any overdue outstanding bill. Such cases should be treated as if a credit limit is not available, and no despatches should be made until the overdue outstanding is paid by the customer.
Deciding credit limits should not be a one-time affair. The limits should be reviewed at least twice a year even in the normal course of business. However, if there are continuous defaults by customers, the limits should be reviewed and revised without waiting for the periodical review. The review should take into account sales history and payments.
Keep a dynamic inventory clearance plan
Like receivables, it is also important to adopt a segmented approach towards inventory. All inventory including raw materials, work-in-process and finished goods should be classified as moving or non-moving based on the nature of the industry, the type of process, the item and its value. As a first step, consider any item not moved for more than six months as non-moving.
Next, check non-moving items for physical availability and the quantities available. Based on this, the management can consider various options to convert non-moving stocks into cash.
Segmenting inventory into moving and non-moving items needs to become a regular feature of any reporting system about inventory but it should go beyond reporting to real action to improve the cash situation.
A company known to us prepared a list of over 500 swatches of various coloured yarns while identifying non-moving items. Then, management looked for options to dispose of the stocks. Some options considered were to sell non-moving stocks at substantial discounts or to make use of the items for some final products which could be saleable. Finally, they chose the option best suited to meet their specific situation.
If non-moving finished goods include some unsaleable items, then management may have to take a decision to dismantle them, make use of the parts wherever possible and sell the remaining as scrap because there will be no gain by keeping the items in stock.
When a company receives orders for export, it is unlikely to make all products as per the standard requirements. Invariably, some export leftovers remain, which need to be disposed of in the local market. If the leftovers are not the standard items sold in the local market, they may command far less price than the export price or a comparable price. Managers should accept the fact and make a decision to dispose of such items at the earliest instead of waiting for a particular price. This can make more sense instead of allowing leftovers as non-moving inventory, tying up cash.
When a company has to dispose of non-moving stocks, it is unlikely to realise the cost at which stocks are valued in the books. This would invariably result in making losses on account of disposal. However, managers should not shy away from taking bold decisions to dispose of them at the best possible prices to convert dead inventory into hard cash. Otherwise, the value of such items would further decrease, putting an additional burden on the company’s profitability as well as its cash.
Eliminate communication gaps
Order management processes should have a well defined communication system to pass information along the chain. Enterprise Resource Planning (ERP) systems can do this job quite well but in case of custom products, there is a need to take extra care. A slight deviation in the customer’s requirement can make product unsuitable for the required application.
One way to deal with this is to hold a meeting with production, planning and purchase departments whenever a custom order is received. In case the number of orders are more, the meeting can be called at regular intervals. If there is any confusion, the concerned department or person should escalate the problem fast to stop producing any wrong product.
Align performance metrics with company goals
When cash is made part of a company’s performance indicators along with sales and profitability, it should also reflect in managers’ KPIs (Key Performance Indicators).
The sales team, for example, should be measured not only on achievement of sales targets but also on collections from customers. Similarly, production managers should have inventory turn as a KPI along with production, machine utilisation and on-time delivery.
The steps to release cash are not one-time fixes and should be followed on a continuous basis. By adopting a systematic approach, exercising more discipline and providing the right incentives, managers can free up extra cash and reduce their working capital requirements.
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