The following is a contributed piece from Peter Kingma, working capital consulting services leader at EY Americas. Opinions expressed are author's own.
Running 26.2 miles sounds out of reach to many, but it is possible by starting with short runs and working toward the goal of a marathon. The same method applies to building a corporate culture focused on cash.
EY-Parthenon Working Capital Advisory Services estimates there is roughly $2.5 trillion tied up in working capital at companies across Europe and the United States. Freeing up that cash could facilitate reaching strategic capital allocation goals.
Leaders seeking to improve their balance sheet and create a cash culture can set their goals high, much like aspiring to run a marathon. The beginning might be full of obstacles and complexities, but perseverance tied to improvement builds the stamina to succeed. The concept is to challenge the organization by using advanced analytics, removing complexity, strengthening processes and incentivizing people.
Based on my experience at EY Americas working with CFOs of organizations of many types and sizes, I suggest three steps to start the journey to create a cash culture.
Set data-driven goals
Far too often, companies set performance targets based on ratcheting ahead of past performance, or they rely too much on benchmarks. Both approaches understate the art of the possible. If my longest run last year was three miles and I increase my goal to five miles, I may never become a marathoner. Benchmarks can also mislead because a given peer group may be poor at generating and preserving cash. Instead, I recommend using analytics to determine cash entitlements. For example, if every customer pays in full on the due date, this represents cash the business is entitled to.
The gap between actual and enhanced collections performance should represent the first set of targets. While the example is simple, this concept is quite advanced and within reach, thanks to new analytical tools. One can apply these techniques to inventory management, commercial terms, procurement, capex investments and more. The key is to use data more effectively and aggressively to set targets. It’s a bottom-up way of looking at cash generation and consumption.
And while we are at it, let’s not rely too much on net working capital. Some businesses have divisions or segments that operate more efficiently than others. One global industrial company had a business segment that operated with negative working capital. When compared with peers at the aggregated level, the company didn’t appear to have much improvement opportunity. But when leaders set aside a business unit with negative working capital and focused on the other segments, they liberated hundreds of millions in cash, which helped with a share repurchase program.
Focus on accountability
To run a marathon, you may start with a run of three miles daily, increase that to five miles and run with a buddy for accountability. Similarly, businesses can measure progress against targets to promote accountability. What happens if you miss the five-mile run for two weeks and scheduled progress calls for a seven-mile run? To promote accountability, it’s important to use metrics that reflect step-by-step progress. For example, suppose a business uses percentage past due to measure its accounts receivable health. That approach may miss many early indicators of a problem and perhaps miss the opportunity to increase intermonth cash flow. If someone owes me on the sixth day of the month but pays me on the 26th and I look only at end-of-month aging (as far too often happens), the situation seems current — but I missed 20 days of cash and an early warning signal of a problem with the customer.
Organizations with a cash culture use metrics to maintain accountability and understand the importance of identifying who has decision rights that impact cash. They align key performance indicators (KPIs) and provide support to help their people make informed decisions. A good example: a buyer negotiates a terrific price on material needed in production but agrees to minimum order quantities or long lead times without fully appreciating the impact on required replenishment. Perhaps they hit their goal to reduce cost but might have unknowingly driven up inventory and increased downstream costs.
The company mentioned above fosters cross-functional accountability, so that cash objectives are on par with other business priorities and metrics. Cash targets are set by the corporate CFO. This stretches the business units to look at all areas that generate or consume cash, such as tax and capital expenditures.
Encourage continuous improvement
When I ran my first marathon, my goal was to finish, and I wasn’t really concerned with my time. But once I knew I could run that far, I set my sights on improving my speed. Generating and preserving cash from operations should be as important as other key business objectives. Strong cash flow provides a business with many opportunities, including paying down debt, investing back in the business and returning cash to shareholders. Leading companies understand that, and our research shows that businesses in the upper quartile of cash performance can widen the gap with underperformers. These companies have set targets using data, align metrics and measurements to promote accountability and empower their people to make informed decisions. They also seek to generate cash more efficiently by focusing on reducing complexity and using digital capabilities to achieve the same or better results with a lower cost structure.
At the global industrial company I mentioned earlier, the focus on cash has evolved from a program to being part of their business operating processes. And progress on generating cash is one of the factors in executive compensation.
A true cash culture requires commitment and discipline that is much like training for and running in marathons and improving results with each race.
The views expressed by the author are not necessarily those of Ernst & Young LLP or other members of the global EY organization.