The key to improving cash flow

Is business an art or a science? It’s a little of both. When it comes to the fine adjustments that can boost cash levels, quantitative analysis can assist you, but it is usually qualitative solutions that drive the improvement.

In its annual assessment of the operational efficiencies of Australian companies consultancy firm McGrathNicol Advisory found the equivalent of $1.2 billion was released from working capital in 2015 by managers who worked out how to unlock cash from their working capital cycle.

“Having access to cash gives you such a fantastic comparative advantage,” says McGrathNicol Advisory partner Jason Ireland. “If there are two companies in one sector who are competitors and one of them has a lot of cash and the other doesn’t, the one with cash has so many advantages.”

The 2015 McGrathNicol Working Capital Report surveyed 111 public companies in eight sectors: building products, construction and engineering, food and beverage, media and leisure, mining and resources, retail, transport and distribution and utilities. The companies in the sample are worth $494.6 billion, or about 83 per cent of the total for the eight sectors.

Overall, the respondents managed to improve practices in 2015 relative to 2014, with ‘days working capital’ – a measure of the cash tied up in working capital – improving from 51.4 to 50.5 days. That improvement was on the back of a three-day improvement in 2014. Importantly, the improvement in cash performance was driven by collecting sales more quickly and reducing inventory levels, rather than holding back payments to suppliers.

It wasn’t a great result for everyone, however. Nearly half the companies surveyed had a worse result than the previous year, with revenue from sales taking longer to be turned into cash. “The best are getting better and opening up a greater advantage for themselves,” Ireland says.

The building products, transport and distribution and retail sectors saw the biggest improvements in the survey, while the media, food and beverage, construction and engineering sectors lagged.

Many businesses struggle to unpick why they are cash poor. Bad practice can creep in during a strong growth phase, where increasing sales and profits create the illusion of good cash flow. In some cases a company may be growing simply because it is giving longer payment terms to customers, Ireland says. “Customers might be attracted because they know they don’t have to pay for quite a long time.”

That may be a deliberate growth strategy, but when such a business plateaus or contracts, entrenched working capital inefficiencies become very difficult to unlock. “That’s when a business will very quickly struggle for cash,” he says.

Managers who want to free up cash need to sit down and map out their working capital cycle. Lax billing practices and high inventory levels are common reasons for money being locked in the sales cycle for too long. “There are lot of entrenched, internal inefficiencies inside some working capital cycles,” he says.

McGrathNicol’s specialist working capital team often finds managers’ best estimates of how long it takes customers to pay can be far off the mark. Businesses may indicate they have 45-day terms, but when you take a closer look at the real cycle, customers are really paying anywhere between 40 and 90 days. “You’re getting false comfort from the terms you’re selling on,” he says. “You’re much better off looking at when people really are paying or, more accurately, the days it takes between making the sale and collecting the cash.”

Suddenly it is obvious why a company never has any cash. “It’s like a lightbulb going on for management teams.”

Delaying payment to creditors sounds like an obvious way to create cash but it can also make a business more unstable. Suppliers will get worried about the payer’s credit quality and may demand payment upfront, which is completely counter-productive, Ireland says. They might even decide they prefer dealing with a competitor.

“The best working capital managers don’t need to stretch creditors,” he says. “The best working capital managers understand their working capital cycle in detail. They know how long they are taking to collect sales and how they might improve internal processes to reduce that measure. They understand the optimal amount of inventory to hold and continually check that measure based on live data.”

Businesses that find comfort in high levels of inventory should understand there is a cost. Some industries simply require a lot of stock, such as building products and retail. However, holding the optimal level is the key to comparative advantage. Ireland says there is no one answer for all companies, but managers can use the McGrathNicol survey to see how they are tracking against peers.

Overall, the picture is good. Net working capital days has been steadily reducing (improving) since the survey started four years ago. In fact the average working capital days in 2012 was 58 days, compared to the 50.5 days recorded in 2015. Firms have been on average collecting more quickly and holding lower amounts of inventory, which allows them to pay creditors faster.

“The best managers are improving cash flow by improving their working capital cycle through internal efficiencies, not just holding back payments to suppliers.”

Words by Jeremy Chunn

The articles represent the views of the authors and not necessarily that of the Bank. You should seek independent professional advice before acting on any matters set out in the articles.