Recent research reports that throughout Europe there are 'substantial savings' in working capital to be had but many organisations are finding it difficult to achieve working capital improvements. To address this shortfall the challenge is to tackle some key internal processes.
Economically many organisations have achieved above average rates of growth for each of the last ten years. For senior executives this has been good news both corporately and personally as the growth in value has translated through to share prices, salaries and bonuses.
However, there are now stark signs of a turning point having been passed and the 'pain points' are beginning to surface. Low cost credit has now dried up and this 'Credit Crunch' is now translated into higher borrowing costs. Many Chief Financial Officers (CFO) believe they are once again being forced into the unenviable position of advising board colleagues to look at increasing their sales prices or reducing their costs in very drastic ways. But before board colleagues start acting on this unpalatable advice perhaps there is more mileage to be obtained by first examining a number of key internal processes: in particular those that can generate significant working capital improvements.
But here is the rub. In most companies CFOs are seen as responsible for ensuring working capital is best managed, but when they take on the challenge to try and make improvements the biggest challenge is getting the organisation to share that responsibility. Even ostensibly simple issues such as valuing work in progress are a minefield as the examples in this article illustrate.
So while the company looks to the CFO to ensure working capital management is optimised, the CFO needs to be armed with the analysis tools and approaches that can achieve significant improvement in results.
Business-as-usual is the time when CFOs' hearts can palpitate because they are very aware that getting a true value for WIP is dogged by internal process problems that are systemic, invisible and have an ongoing negative impact on working capital. Though CFOs recognise the symptoms, when the root causes are in other parts of the organisation they are harder to pin down and eliminate. Without an external spur to force the analysis and implement permanent improvements it takes a lot of collective board level resolve to get a focus on fixing WIP problems, and all the other factors that impact working capital, even though the rewards always far outweigh the effort.
Only rarely does an external spur such as Mergers & Acquistitions and Joint Venture activity force everyone to unravel the mysteries of WIP. Due diligence deadlines leave them no choice and what is uncovered must be resolved as it could well cause the deal to collapse or at least stall.
Business-as-usual harbours the real risk of hidden lost value in work in progress as the focus of the board's attention could be elsewhere. No wonder CFOs have palpitations!
Its intangible nature gives rise to many complex uncertainties in relation to WIP valuations. It is the underlying processes and disciplines around them that are the cause for concern. In particular the processes associated with charging labour and expenses to WIP accounts, and how revenue is recognised, can highlight major valuation issues.
A notable example is where WIP is relieved by Cost of Sales that are themselves generated by an invoice being raised. Cases are legion where CFOs have personally had to write off vast sums of both debtors and WIP amounts simply because invoices turned out later to be uncollectible. Often such invoices had been raised by accounts departments in line with contractual terms; the accounting system had 'flagged' that the invoice needed issuing!
The missing step, and maybe in retrospect an obvious omission, was to make some comparison between the value in the WIP accounts and that which was a true reflection of work that had been done to the accepted standard so that the customer was happy to pay for it. With a minimum of communication between finance and the people responsible for working with the customers such a process for raising invoices could only be described as 'on a whim and a prayer.'
Imagine the anger of customers receiving incorrect invoices and the immense amount of paperwork needed to correct the problem!
Identifying such process issues is time consuming but without such checking the working capital accounts could all be in need of adjustment. With luck the hub of the problem may simply be that in the WIP accounts people have posted labour hours and expenses to 'dummy' accounts which never or rarely get invoiced. However, fixing small indisciplines isn't often the end of the matter. It is best to assume that it's an indication of more complex process problems waiting to be found.
In this sector it is common practice to raise invoices, payment milestones, certificates and so forth where deduction of a retention is for work to be carried out at a later date, and then and only then are those retentions paid upon 'final certification' of work done. Should these payments not be forthcoming it may indicate that the work was not completed satisfactorily. Retentions can 'muddy' the waters concerning both debtors and work in progress. Mapping all the processes of each of these situations uncovers common and systemic problems associated with particular customers, subcontractors or the employer's workforce.
Getting to grips with and understanding these more complex root causes leads to WIP re-valuations and could affect valuations of debtors and payables too.
A first pass at analysing the internal processes generally alleviates the major uncertainties. For example in this sector some aspects of WIP may be calculated using certain values associated with gaining intellectual property rights on part completed products.
Another example could be that it is often possible to establish correlations between a customer or a group of customers who are withholding cash and a specific and common reason for failing to pay. While this makes the problem of collecting cash very visible it can also be the tip of the iceberg if, for example, customers are holding back cash because the quality of a particular product is a problem. Could the value of the WIP accounts associated with these products be at risk if the products are harbouring the same quality problems?
And of course in this example we are assuming that the company's debtor section accurately records reasons for non-payment of invoices and that they deal with such non-payment matters in a consistent manner through disciplined feedback procedures pointing to where the root causes exist. The reality is more likely to be far fuzzier processes so the WIP valuations may well need further revision - downwards!
Cash flow, or the lack of it, is critical in appreciating how to value a company. Though not the only factor that impacts on working capital, work in progress has a large bearing on the company's value.
Even if the concern is insufficient cause for a CFO to miss a heartbeat, a sense of frustration and unfairness can make even the most altruistic CFOs feel they are shouldering an unbalanced share of the concern. Colleagues heading up other functions may be blissfully unaware of the hidden risk to the company's value of poor processes that impact WIP and working capital.
During business-as-usual the concerns around value should be no less acute than when the business is given an external imperative to sort out problems. Collectively the board needs to provide the impetus to find out how robust the processes are. It is very likely that an investigation will uncover real value draining away.
And it's not just the mechanics of processes that need improving. Behavioural issues have to be addressed; an area that is often at best in the peripheral vision of tough board members. But people's attitudes to suppliers and customers have a large impact on how the whole process chain of materials and services interact during both the good times and particularly the hard times, when cash flow and working capital are under strain.
Working capital management is often seen as the responsibility of the CFO. However, as the examples above illustrate, working capital and particularly aspects of WIP are mainly influenced by people in all other functions. For the CFO to fulfil this given responsibility means finding a way to engage others in using appropriate tools to analyse and improve the position.
Three factors ensure a successful outcome to a working capital & cash flow improvement programme.
Firstly, involve and so develop managers and staff. This ensures that everyone gains insights into how they work and how they contribute to improving the working capital and cash flow position.
Secondly, because the analysis team members develop a unique perspective on the organisation, understanding cross-functional causes and effects, and exploring issues and problems in depth, some members should then be the nucleus of an implementation support team.
Thirdly, by addressing process design as well as behaviours and attitudes it will ensure that both working capital and cash flow improvement are always very much at the forefront of people's minds.