Is it supply chain management or is it strategy? It's finance, General!
On aggregate in Continental Europe, working capital represents large amounts (c. 15% on capital employed). Customer credits (and symmetrically, supplier credits), which are commercial loans between companies, amount to nearly three times the amount of short-term loans granted to corporates.
The similarity between the amount of working capital and that of net debt is not completely coincidental, as often these two items behave in concert. An increase in working capital means an increase in net debt, as a large number of companies can testify following their experiences in late 2020. A drop in working capital often means a drop in net debt, as a large number of companies can testify following their experiences in mid-2020.
Finally, the problems and the amounts of working capital are not identical for all sectors. There is a world of difference between industry (management of work-in-progress, credit limits for major customers, etc.) and the services sector.
Working capital is an investment, like any other, even if on occasion there is less choice involved (for example, when a customer “forgets” to pay by the due date and turns the supplier into its unwilling banker). As an investment, it should be managed lucidly and properly. Reducing it in order to reduce the company's need for funds and to improve its earnings is a possibility, but it is not the only possibility.
From the company's point of view, what is working capital?
From a more economic point of view, working capital can be:
Working capital results from the company's strategy. For example, when a company decides to get involved upstream in order to secure its supplies (ArcelorMittal owns iron-ore mines that provide it with 65% of its consumption), or downstream in order to fill the gaps in a retail network that is patchy or not yet established (SEB runs close to 1,300 shops in 45 emerging countries such as China, Turkey), then working capital is necessarily increased. Similarly, when the company decides, like Indesit did, to outsource part of its production to Eastern Europe, South East Asia or China, then margins rise (or don't fall), but working capital increases, since these subcontractors just don't have the financial structure necessary to grant Greek-style payment periods!4
The level of working capital is also the result of a financial arbitrage between margins and costs. We know of a magazine group that pays cash for its paper supplies. It is able to purchase its paper at a knock-down price, as it is in a very good position to negotiate discounts at a higher rate than that at which it could invest its cash, from suppliers whose need for cash is constant given the extent of their investments. Our magazine publisher's working capital is mediocre (practically no supplier credit), but its margins are outstanding!
Another example is the public works sector, which is structured around customer advances that more or less cover the cost of the works, and more, for the best of them. Working capital is low, but then so are margins. You can't expect your customer to give you everything!
The company grants discounts so that customers will pay quickly, which means that working capital level is low and that cash is quite plentiful but also that margins will decline. This is why in the USA it is standard to offer customers the option of paying at 30 days or of paying at 10 days and getting a 2% discount. As the yield to maturity of this commercial offer is 44.6%, very few buyers are able to resist the temptation! (And those who do send out a signal of a pitiful financial situation which may alarm suppliers.) Sales, when they are exceptional, are also a way of buying cash.
There are four ways of approaching working capital management:
Only the first two of the above ways of approaching working capital management will lead to the generation of cash without weighing heavily on the cost structure.
Working capital management is also a cultural issue. We saw in Section 11.3 that payment periods in Europe differ widely from one country to the next.
Some companies have a more developed cash culture than others, either because of the financial difficulties they have had to face in the past (carmakers in the 1980s), the influence of their shareholders (LBO funds make cash an essential lever of their culture6) or the approach of a manager (former financial director), which have made them sensitive to cash from a very early stage. Other firms have less of a cash culture because financial conditions make cash less of a pressing problem or because their culture is far removed from such preoccupations (engineering firms, firms involved primarily in research and development, etc.).
In other words, if a cash culture is to take hold within a company, as an add-on to other cultures rather than a replacement, it will require a long learning period, patience, diplomacy and, above all, the support of general management, as it often leads to a root-and-branch overhaul of established practices with which staff are familiar and comfortable.
Finally, even though all employees can be expected to try to enhance their performance and improve their weak points, we can't help being a bit sceptical. Division managers are rarely superhuman. If we set division managers multiple targets of growing the market shares of their products, increasing margins, ensuring good relationships between labour and management and seeing to it that their divisions comply with corporate culture, not forgetting to innovate along the way, and then we also ask them to reduce their working capital over and above the obvious waste that needs to be avoided, we are perhaps asking too much of them. These multiple objectives could hamper managers in the performance of their tasks, with the risk that they are unable to perform properly and fail to achieve any of their goals.
We know of a multinational firm that has become a leader in its field as a result of innovation and highly effective marketing. Its margins are enviable and its after-tax return on capital employed is just under 20%, yet its working capital can hardly be described as good. Is it possible to be good at everything all of the time?
This rather existential question has, unfortunately, to give way to the more mundane. The following sections look at the operational and more concrete ways of reducing working capital. This may seem a bit dull, but it is the nuts and bolts of the field. Stay with us and be patient.
Managing receivables involves:
The last two points are intertwined, as the risk of default increases in direct proportion to the length of the payment period. Payment periods for Spanish, Italian, Portuguese and Greek groups are twice as long as in Scandinavia, and, here, the default rate is twice as high.
Altares estimates that 45% of invoices remain unpaid on their due date and that 3.2% of them are still unpaid 90 days later.
Payment periods are often described as the result of four factors:
The general terms and conditions of sale make provision for payment periods that are set by the company and are in line with its strategy, standard industry practice and local customs.
When sales reps offer exceptional terms and conditions of payment, this means that the financial manager has made sure that they come with a commercial gain (higher price, larger volumes). If this is not the case, then sales reps will have to go back on their word, which is never easy with a customer who has been allowed to slide into bad habits! This is why it is best not to let sales reps make decisions on exceptional terms and conditions.
When customers fail to meet payment in full and on time, they are bending the rules and stretching the terms and conditions of sale which they signed up to. The EU Directive on the reduction of payment periods makes provisions for penalties for such infringements: late payment interest calculated at the Central European Bank rate plus 10 points (10% in mid-2020). In certain countries, the law also makes provision for civil and criminal penalties (fines). Even though suppliers are under an obligation to apply them, they may think twice before doing so, given the potential negative consequences of such action.
In order to avoid ending up in this situation, it is in the company's best interests to:
Delays resulting from the internal malfunctioning of the company are, in theory, the easiest to remedy, even though this often involves overhauling the company's administrative processes, while always keeping in mind the playoff between costs and efficiency. It's also a good idea to look at the time it takes for invoices to be issued because the payment period starts as of the date of the invoice, even if the product or service has already been provided. Checks should be carried out to ensure that the invoice bears the correct address and that the quantity invoiced is identical to the quantity ordered.
As a defaulting customer can cause a company to go bankrupt, it is in the company's best interests to protect its receivables from any risk in this regard.
There are several simple measures that can be put in place:
This is the province of the credit manager, generally attached to the finance department, who is responsible for trade receivables, customer risks and collection and is also required to optimise performance, working alongside the sales departments.
At a later stage, the credit manager may have to make use of the services of collection firms (Intrum, Ellisphere, Pouey, etc.), which handle the recovery of unpaid debts on behalf of companies, either amicably or through the courts.
In order to avoid such situations, the company can take out credit insurance. This is an insurance policy which guarantees the reimbursement of the unpaid debt by the credit insurer (Coface, Atradius, Euler Hermes, Zurich, SACE) in exchange for an insurance premium of between 0.10% and 2% of sales covered.9 It is rare that full compensation is paid out as the company will still have to pay the insurance excess, which will be between 10% and 30% of the amount of the debt. The insurance payout is made either when the purchaser of the company's goods is declared insolvent or at the end of the waiting period before payment. In order to avoid carrying only the risks that the company knows are bad risks (adverse selection), insurance companies often insist on covering the whole of the company's customer portfolio.
Credit insurers provide three services:
Credit managers also have other tools at their disposal to protect the company against defaulting customers:
This item is often neglected as company buyers are often more keen to negotiate good prices than to negotiate advantageous payment periods.
But this is a pressing need with the development of credit insurance. If a company's supplier has taken out credit insurance to cover its receivables, and if the company pays after the contractual payment period and the supplier declares a default on payment to the insurance company, the company will be identified as a bad payer by the insurance company and this news will spread very quickly on the market.
Management of trade payables will mainly involve:
The ability of a company to manage its inventories well is dependent on several parameters and on how well the company manages these:
Experience has shown that when a company takes a serious look at its inventory levels, it can achieve impressive results. We know of a company that has been able to reduce its inventories by 23%, cutting them from 70 to 54 days of sales. Progress in logistics and IT management have played a large role in these improvements. However, it would be fallacious to believe that it is always best to keep inventories low. Inventories remain an investment which results from a playoff of financial cost versus the flexibility gained.
As for the management of receivables, managing inventories involves action to combat waste and more structural action.
Action to combat waste includes:
Structural measures include:
Financial managers will not be able to put in place measures for managing working capital without the close collaboration of operational managers responsible for purchasing, stocks, logistics, production, sales and human resources, over whom financial managers have no authority. Over and above the fight against waste, managing working capital often quickly leads to strategic decisions involving the firm's commercial, production and logistics policies.
Financial managers will, this time internally, have an opportunity to demonstrate their teaching skills and negotiating talents.