As the global economy continues to recover following the COVID-19 pandemic, the treasurer’s strategic value to the organization is evolving toward efficiently managing working capital, to meet the growing liquidity needs of their expanding companies. The question “where’s my cash?” was, of course, a top priority from CFOs to treasurers during the pandemic. However, treasurers are now asked to not only safeguard cash, but also to become a more strategic business partner, to ensure corporate free cash flow and liquidity goals are realized. As a result, working capital management has become the main focus area for CFOs to challenge their treasury, FP&A and corporate controller groups, to minimize working capital cycle and therefore improve free cash flow.
Importance of Working Capital
Working capital is the liquidity available to the treasurer to satisfy their company’s short-term financial obligations: current assets less current liabilities. Put another way, by optimizing the various working capital components, treasurers can reduce the cash conversion cycle, which is the amount of time cash is tied up in working capital. The cash conversion cycle is comprised of days inventory outstanding (DIO), days sales outstanding (DSO) and days payables outstanding (DPO). As the global economy returns to growth, treasurers are tasked with proactively managing working capital as businesses expand into new markets and geographies, which can lengthen the cash conversion cycle by extending DSO and DIO. As an increasingly strategic corporate finance function, treasurers have a unique opportunity to work cross-functionally to drive working capital initiatives, track their effectiveness and positive impact to free cash flow.
Cash Conversion Cycle – Priorities and Business Implications
Before embarking on any working capital initiative, it is critical to collaborate cross-functionally to understand what implications a new working capital solution may present to the underlying business and its partners. Although the cash flow benefits of reducing the cash conversion cycle are clear from a treasury priority, it is important to recognize the components of the cash conversion cycle and how working capital optimization programs could impact the underlying business. The goal is to minimize the cash conversion cycle by reducing DSO and DIO, while increasing DPO. However, if the focus is to improve any one of these metrics in isolation, there may be negative implications to other parts of the business. Inventory management, and specifically reducing DIO, is a good example of competing priorities between the treasury and sales teams. Higher levels of inventory may be important to the sales team to ensure they can meet demand and not forego a new sales opportunity. However, from a treasurer’s perspective, a growing inventory balance and DIO will have a negative impact to working capital, and ultimately free cash flow.
One component of working capital that has been the recipient of significant innovation in recent years is accounts payable and extending the company’s DPO. Accounts payable is the working capital component where corporate finance has the most control, however treasurers must take an internal leadership role to educate and influence their corporate finance colleagues of these benefits. Corporate functions have a tendency to operate in silos, where specific department objectives can be contrary to the overall strategic benefits to the company.
Utilizing their leadership roles, treasurers can educate their finance colleagues of the strategic benefits of an effective working capital program, which include improving free cash flow and securing internal low-cost funding (improved working capital being the lowest-cost source of cash). These groups include accounts payable, procurement, legal and the broader treasury team. Historically treasurers and accounts payable managers could delay payments to suppliers as a taxing method to extend DPO. The negative implications of this approach are apparent however, mainly stressing relationships with key suppliers and the resulting volatile cash flow levels within the quarter.
Most recently, supply chain finance and related technology solutions continue to be an effective working capital tool to extend DPO. In a supply chain financing solution, customers with strong credit ratings can often extend payment terms to their suppliers by involving a financial institution into the solution. Under a supply chain finance solution, the supplier receives an accelerated, but discounted, cash receipt at lower effective rate than they could finance externally, while the customer is able to delay their payable to the financial institution and thereby improve its DPO. Under this solution, the treasurer has extended the DPO, reduced the cash conversion cycle and improved free cash flow, while maintaining good relations with the supplier.
Treasurers, as safeguards of their company’s global cash and short-term forecast, have the responsibility to accurately monitor the future liquidity demands for their company. Treasurers can use this intelligence to align working capital and strategic cash flow plans against actual performance within the current quarter. Effective working capital solutions, including supply chain finance programs, can be strategic toolsets that enable the treasurer to proactively improve working capital, reduce the cash conversion cycle, and ensure short-term liquidity demands are satisfied and quarterly cash flow targets are achieved.
This article initially appeared on gtnews.com on July 25, 2014.