Working Capital seems easy enough to understand. Divide a company’s current assets by its current liabilities and you get a ratio that helps you determine how easily a company could cover its short term debt. This is generally referred to as how liquid a company is. However, this doesn’t always paint a clear picture.
In today’s supply chains, it’s easy for current assets (i.e. inventory) to be caught up for months at a time. It is not uncommon in some industries for the cash-to-cash cycle time from procurement of supplies to receipt of payment from customers to exceed six months. In the meantime, manufacturers are stuck paying for raw materials they haven’t sold yet.
Additionally, some industries are volatile. You may have months of inventory tied up in your supply chain that you have already paid for but will not be able to sell. Both of these examples highlight two key challenges that manager’s face while trying to maintain a healthy working capital: cash-to-cash cycle times and inventory optimization.
Addressing the Issues
Let’s first define cash-to-cash cycle and inventory optimization:
1. Cash-to-cash cycle time is the amount of time it takes your working capital to move through your supply chain from raw materials to receipt of sales. Any time your cash-to-cash cycle time is longer than your payment schedule, you’re paying for materials that you have not yet sold.
2. Inventory optimization is more or less balancing supply and demand. It refers to having the right amount of inventory on hand to meet your customers’ needs but not a penny more.
The Silver Lining
The thought of managing cash-to-cash cycle times and inventory optimization is enough to keep even well-seasoned managers up at night. There is, however, a silver lining to these two issues.
In most cases, improving one improves the other. When you shorten your cash-to-cash cycle time, you are shortening the amount of time it takes to get inventory to your customers. This in turn means you need to have less inventory on hand at any given time to meet demand. So, when your company successfully addresses one issue you will most likely see improvements in the other.
To find ways to address these issues, let’s look briefly at the procurement process and then take a more in-depth look at options within the supply chain.
The Procurement Process
At the very beginning of the procurement process, we find the ever-troublesome task of forecasting. Using big data to make informed decisions is a given in today’s business world, but some of the most successful businesses are moving beyond descriptive and predictive analytics.
To address the challenge of forecasting inventory quantities and determining exactly how much working capital to keep tied up in raw materials, managers can leverage prescriptive analytics.
Prescriptive analytics moves beyond simply translating data to actually offering the best course of action (given specified business goals) by evaluating millions of scenario outcomes. This action-oriented form of analytics leads to lower margins of error in forecasting and frees up working capital by reducing the amount of safety stock necessary to maintain service levels.
Finding Opportunities within Your Supply Chain
While more accurate forecasting can improve inventory planning, it’s merely a tool to help you better understand your demand. To find the most effective opportunities, we need look for inefficacies in the supply chain itself. Some of the places you might find them include:
- Your supplier and customer relationships
- The physical distance your inventory travels from your supplier to your customers
- The design of your products, how you build them, when to build them and what you choose to build
- The support of financial partners
Now let’s take a look at some real-life examples of these discoverable opportunities.
A healthy relationship with your suppliers can completely change the way your company does business. When a manufacturer and its suppliers collaborate, they can create new opportunities to free up working capital that is mutually beneficial.
One example of this is a manufacturer leasing warehouse space on its property to a trusted supplier. The supplier would maintain ownership of the raw materials until the manufacturer removed them from the warehouse for use. This drastically reduces the amount of working capital the manufacture has tied up in raw materials, and the cost of the warehouse can be recouped through rent paid by the supplier. The supplier also benefits from this arrangement as it ensures a long-term relationship with the manufacturer (a lease covering the cost of the warehouse would likely span years).
Furthermore, the supplier could offer the manufacturer what essentially amounts to zero lead time while not incurring the outrageous costs of delivering goods several times a day.
This sort of long-term relationship can be daunting to companies who, in the past, have somewhat bullied their suppliers. During the recession, for example, it was not uncommon for manufacturing companies to simply inform their smaller or less vital suppliers that they would be extending their payment schedules.
These smaller suppliers were afraid of losing business in what was already a difficult time, so this strategy did work for a while but was ultimately damaging. This article from the Harvard Business Review speaks at length on the importance and benefit of building close relationships with your suppliers. Had those same companies who forced their suppliers into giving them extended payment schedules decided to work with their suppliers in a mutually beneficial way, they could have reduced their cash-to-cash cycle time while building a stronger supply network.
Companies can also look inward to find opportunities. There are countless ways to free up working capital within the manufacturing process. One major way to do this begins with designing modularity into the company’s products. By building modular products, your company can meet the demand of the market while carrying less inventory. It does this by building a base product and offering small variations in design that can be completed when a customer places an order. This reduces the cash-to-cash cycle time by reducing the amount of complex products a company needs to produce and by making it possible to have products finished in locations closer to customers.
In some cases, manufacturers may be able to sell unfinished modular products to other companies who can finish them per a customer’s needs. In this scenario, the manufacturer would be able to receive payment for its products before those products ever even reached their end consumer.
This may all sound good in theory but switching to a modular design is no small feat! To execute such a large change in a cost effective manner, you may consider first adopting a more integrated approach to your planning process. With this types of decisions, it’s crucial companies are certain that the changes they’re making are a) aligned with long-term company goals and b) are taking into account all functions within the organization.
This approach also helps with change management, as it facilitates frequent, company-wide communication.
Going modular is not a new idea — in fact, the idea of postponement was first published in academic literature in the 1960’s. The article also contains a fantastic example of how a company can use modular products to help free up working capital by reducing inventory.
In the end, the solution to addressing working capital issues may even be as simple as simple as getting some financial support. Some of the opportunities we just explored are extremely involved undertakings — even for larger companies that can leverage capital to push things forward.
Smaller companies may not have the luxury of exploring all of these options. For many smaller companies, the solution to covering current liabilities while working capital is tied up along the supply chain is much simpler. Options like asset-based lending can offer your company access to the monetary value of your accounts receivable before your customers pay their bills.
Ultimately — whether the solution to better managing working capital lies in getting more insights from predictive analytics by leveraging prescriptive analytics or building closer relationships with your suppliers — understanding and monitoring cash-to-cash cycle time and finding ways to optimize inventory are crucial to addressing working capital management challenges.
Editor's Note: This post was originally published March 20th, 2016 and revised September 30th, 2018.