The Principles of Cashflow and Working Capital

Management

- An operations perspective

Nishit Nisudan, Consultant, Total Logistics

5a Market Place Wokingham Berkshire RG40 1AL United Kingdom

www.total-logistics.eu.com

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The Principles of Cashflow and Working Capital Management

Synopsis

This paper looks at ways in which the supply chain and operational practices in an organisation can be changed or optimised to improve cashflow and enable effective management of working capital. We will describe 7 practical approaches to improve cashflow and highlight other ways to tighten the management of the working capital within your business.

Introduction

The global economic recession of 2008 highlighted a major problem that even successful businesses face today. It showed us that even organisations which had been making healthy profits in the past were not immune to financial pressures, bankruptcy or insolvency. It showed us that a business can survive for a short time without sales or profits, but without cash it will die. Improving cashflow and effective management of the working capital in any business is therefore critical. This very aspect of cashflow highlights the vital importance of cash to modern businesses, especially small and medium enterprises.

The purpose of this mini white-paper is to look at ways in which the supply chain and operational practices in an organisation can be changed or optimised to improve cashflow and enable effective management of working capital. We will focus on the 7 key principles of improving cashflow, plus we will highlight other tools or systems that could help improve the working capital management of your business.

What are cashflow and working capital?

Cashflow can be defined as the movement of money in and out of any business. While profit, turnover and market share are all indicators of success, if there is no cash in the bank to pay monthly bills, wage runs and loan payments then the business will fail. Cash-flow management is thus vital to the health of a business and it is in the day-to-day management of a business that cash can be most effectively controlled. It is thus the life blood of all growing businesses and is the primary indicator of business health. The effects of cashflow are real, immediate and if mismanaged, totally unforgiving. Cash has to be properly managed, monitored, protected, controlled and put to work.

A cashflow cycle can be described as a cycle in which your business uses cash to acquire resources. The resources are put to work, and the goods and services are produced. These are then sold to customers, you collect receipts and deposit the funds and so the cycle repeats. But what is crucially important is that you actively manage and control these cash inflows as well as outflows. It is the timing of these flows which is vital to the success, or failure of a business. It must be emphasised that profits are not the same as cashflow It is possible to project a good profit for the year and yet face a significant and costly monetary squeeze at various points during the year.

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The figure below illustrates a typical cashflow cycle

Figure 1: A typical Cashflow cycle

The figure clearly illustrates the importance of cash in a business. The requirement starts when the raw materials have to be ordered to fulfil the requirements of production. Cash is also used during the production process in the form of overheads. It is also required for storage (inventory) and distribution of the products till the products reach the customers in the market. This requirement of cash is primarily fulfilled by the customers when they pay for the products they have bought. This is a small illustration of the complex cashflow cycle. Another similar term is working capital. Working capital is the comparison of current assets to current liabilities.

The most important or vital aspects for effective working capital management are inventory, accounts receivable and accounts payable. Companies usually underestimate the importance of working capital management as a means for freeing up cash from inventory, accounts receivables, and accounts payables. By effectively managing these components, companies can gradually reduce their dependence on external funding and can use the released cash for further investments or acquisitions. This will not only lead to more financial flexibility, but also create value and have a strong impact on a companys enterprise value by reducing capital employed and increasing asset productivity.

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The figure below defines working capital

Figure 2: Working Capital defined

Therefore, working capital in its simplest sense is the difference between the Current Assets and the Current Liabilities of an organisation. The assets include the cash the company has in its bank accounts, stocks, the pending receipts, investments and inventory. Liabilities consist of the payments due, taxes due, dividends and the loans the company has to pay.

Operations Management the 7 key principles to improving Cashflow and Working Capital management

Limited research has been done on the impact of the supply chain on cashflow and working capital. The focus has primarily been on the financial side of a business. Total Logistics employs a variety of solutions that have a direct or indirect impact on cashflow and working capital. They are detailed below:

Inventory Management Inventory includes the work-in-progress, raw materials and finished goods of an organisation. It is one of the most important factors which can help manage working capital effectively and improve cashflow. High working capital often implies that too much of cash is tied up in either receivables or inventory. Excess or inappropriate inventory is one of the most neglected aspects which can account for significant savings obtained from working capital optimisation projects. By streamlining processes within the company, and processes involving suppliers and customers, companies can minimise the inventory throughout the value chain. Inventory can be reduced by enhancing the forecasts, proper demand planning (based on forecasts and trends), adoption of just-in time production-delivery-logistics concepts, lean management, reduction of wastes (lean philosophy), and automated inventory replenishment systems enabled by technologies such as CPFR, VMI and ERP.

Fulfilment, shipping and handling - The proper fulfilment of a customers order is also very important. The cash conversion period is significantly increased if the business is unable to supply to specification or meet the requirement within the agreed timetable. For any business that sells products rather than services, this occurs when the business fails to control its inventory and/or its production process. For a service related business, this occurs when the business does not manage the skilled resources to provide the requested services properly.

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Production and Materials Planning process This process is critical to the management of cash because if the wrong product mix or too much of material is scheduled for production or if enough capacity is not available to fulfil all the orders in time, inventories will increase and consume cash. Proper planning followed by action in the form of implementation of a master production scheduling system such as kanban, adoption of a MRP and/or ERP systems, and embracing Lean philosophies or JIT practices can help plan and schedule the production, as well as reduce inventories.

Increasing Sales Cashflow can also be improved significantly by increasing sales. The supply chain can influence sales in many ways, such as ensuring on-shelf availability, prompt and effective delivery and correct replenishment. Conversely sales can be lost through having the wrong stock in the wrong location at the wrong time.

Increasing product margins (profits) The product margins can be increased by cutting down on costs and/or increasing the sales price of the product. Costs such as purchase costs, overheads and quality costs can be reduced. One can also increase margins by increasing prices or by changing the product mix based on the demands and market trends.

Reducing costs By reducing the cost of the product (raw material, overheads, labour, operational costs etc.) one can increase the margins and thus contribute to increasing the cashflow and optimising working capital.

Elimination of non-value added time An appropriate step towards reducing tied up working capital is the elimination of non-value-adding time. The indicator which is used to measure how long cash is tied up between procurement and sales is the cash-to-cash (C2C) cycle, which is defined as the time elapsed from the payment of cash for materials or parts through to the receipt of cash for sale of the finished product. The supply chain influences this process in many ways, including transport in/out, internal processes and fulfilment/despatch.

Therfore, cashflow and working capital can be improved and managed in various ways. We have looked at this topic from not only a financial perspective, but also an operations perspective.

This paper can be concluded by re-iterating that both Cashflow and Working Capital are highly critical and the very lifeblood of an organisation. Companies cannot survive without adequate cashflow and working capital. They are the foundation for a healthy, sustainable and profitable business. Cashflow is important because it keeps the business running and helps operations run smoothly without interruptions, while working capital management is important because it contributes to improved cashflow, optimises inventory and helps the business maintain its value for customer and shareholders.

The supply chain can no longer be viewed as the bolt on process that merely fulfils a tactical, operational service to a business. The supply chain is a strategic tool that can effect sales, margins and of course cashflow and working capital. An optimised supply chain is a key influence on a business and its ability to succeed in a challenging economic environment.

Total Logistics has successfully employed a number of tools and strategies that not only optimise supply chain operations, but also have a direct and positive impact on cashflow and working capital management.

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Example 1- a leading distributor of electronic components

This client had a SKU range of tens of thousands of products and delivered across multi-channels and their purchasing and inventory strategy relied on manual processes and traditional estimates. This lead to large discrepancies in availability and stock holding with a significant impact on service levels as well as cashflow and working capital. Working closely with the client, we built a bespoke inventory analysis tool that was integrated into their business planning process. The tool advised on effective control parameters at SKU level, reducing the manual interventions and minimising administration. As a result-

The service was fully implemented and started delivering results within 3 months Stock availability increased by 10% (to 93%) Stock levels were reduced by 25% Significant improvement in working capital The tool out-performed the inventory management software deployed in other

divisions of the company

Example 2- a global manufacturer

Our client is a global manufacturer, delivering products on a b2b and b2c basis. The supply chain was managed across a number of sites and needed an immediate optimisation of processes and inventory management in advance of a potential consolidation exercise.

Productivity improvements of 10% were delivered through changes to layout, processes and procedures, and support functions such as customer service and manufacturing supply.

The work steps for change programme were structured as a 6-Sigma project for internal implementation.

The storage media was aligned to the inventory profile to increase storage capacity by 6% at minimal cost.

We then re-focussed the business strategy towards the continuous improvement programme for the current site and a Greenfield strategy for the longer term operations.

Total Logistics is an independent management consultancy, specialising in all aspects of commercial supply chains, from strategy definition to implementation and project management.

For further information or to arrange an initial discussion on how this may benefit your business, please contact:

stuart.hearn@total-logistics.eu.com

Tel - +44 (0) 1189 773 027 www.total-logistics.eu.com