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In Today’s Email:

• 🏎️ Tactical Guide to Driving Working Capital

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A WORD FROM THIS SEASON’S SPONSOR…

THE DEEP DIVE

Making Working Capital Work: The 15 Drivers of Working Capital

This is the seventh week in an 8 week season covering how to build a culture of cashflow obsession in your business.

“Are you kidding me?”

Not the response I expected. The feisty Accounts Payable clerk didn’t let me get a word in. She continued:

“You’ve got some balls calling to demand payment. We’ve been trying to pay you for 3 months. But your invoice is wrong. Like every invoice you’ve raised in the last 2 years.”

Oh.

10% of our receivables ledger was over 90 days old.

I'd recently joined this business in the middle of a cash crisis. We couldn’t afford to get paid late.

The team had told me that the overdue debt issue was a resource issue in the collections team.

I smelt bull sh*t, so I decided to get on the phones myself for a day. To see first hand.

This - along with several other calls like it - confirmed my hunch.

The receivables cycle was broken. From order through to cash.

This was going to need more than a few weeks of heavy handed collection calls.

Invoice disputes were stacking up faster than we could deal with them. All our customers could not be wrong. We had an invoicing issue, likely a corruption within the price file. It needed identifying, and fixing at source.

Only then could we work through the back log of disputes invoice by invoice.

In the mean time, we had almost $20m of working capital trapped.

A modern day horror story for the cashflow conscious CFO.

Last week we designed our business model to include working capital.

Today we focus on the tactical tools and tips for good day to day working capital management.

But before we get into this week’s content, let’s recap where we are in the series:

• Week 0 - Cash is not king. Cashflow is.

• Week 1 - Maintainable Free Cashflow. Cash generation vscapital allocation.

• Week 2 - Reporting cadence and metrics for cashflow performance.

• Week 3 - 13 Week Cashflow Forecasts.

• Week 4 - 18 Month Cashflow Forecasts.

• Week 5 - Working Capital Design & Negative Working Capital

The most common way to measure working capital is through the Cash Conversion Cycle (CCC), and it’s component calculations:

• Days Sales Outstanding (DSO)

• Days Inventory Outstanding (DIO)

• Days Purchases Outstanding (DPO)

Where CCC = DSO + DIO - DPO

This chart articulates how the measures work together:

I’m not crazy on the CCC measure, I don’t use it in my business. But I’ll save that for another day.

Regardless of my personal preferences, CCC (with DSO, DIO and DPO) is the lingua franca of working capital.

So we’ll use it for this post.

Each of the components measure the effectiveness of the business process that sits behind it.

• DSO measures the Sales Order to Cash cycle (O2C)

• DIO measures the Forecast to Fulfill Inventory cycle (F2F)

• DPO measures the Procure to Pay cycle (P2P)

In any accounting transaction, the cash transfer is often the last step of the process.

Take the O2C cycle:

• A sale gets agreed.

• Customer raises PO.

• Service delivered.

• PO receipted.

• Invoice raised.

• Invoice match fails.

• Discrepancies resolved.

• Invoice matched.

• Payment terms lapse.

• Only then is cash remitted.

If any step of that process fails. The wrong product number on an invoice. Short delivery of an order. Faulty goods. Price is out by a rounding error. Then that will hold up the transfer of cash.

Single points of failure, throughout the chain.

It reminds me of that show Wipeout. Obstacles trying to knock contestants off at every stage.

That contestant is your cashflow, and the route through the obstacles is good process.

Process. Process. Process.

Another horror story...

A while back, I spoke to a CFO of a large public company who botched an ERP installation. They couldn’t invoice for six weeks.

SIX WEEKS!

They had amassed over $500m of accrued income by the time they got on top of it.

A $500m working capital hit. Unplanned, and built in six weeks.

They are lucky it didn’t kill them.

Here is the key point.

Working capital cycles are complex. Business processes that cross many different functions. Full to the brim with inefficiencies. If you want to root out those inefficiencies you must go deeper.

If you think working capital management is just about payment terms, that is lazy. And will leave free $$$ on the table.

We need to break down each of the cycles into the organizational competencies that drive those cycles.

As this chart explains:

This gives a model for evaluating your working capital effectiveness. And highlights areas to target.

Each row in the chart is a driver of working capital. And a capability your business needs to build to optimize working capital.

And relevant business cycle (O2C, F2F, or P2P) is mapped in the columns.

Now let’s take each in turn.

Business Fundamentals

The fundamental truths of your business set the range in which your CCC can sit. It sets the constraints. The key is including working capital design as part of the strategy setting for a business:

1) Business Model. This is the area covered last week. It’s so important, it got a whole post of it’s own. Designing your unit economics to consider working capital dynamics with real intent.

2) Supply Chain Design / Service Model Design. How you design your supply chain behind your business model has a huge impact on your CCC. Do you manufacture or resell? Where is the manufacturer? Direct ship or warehouse? All this influences CCC. Same principles for a service business. How the service gets delivered will drive CCC.

Effective Payment Terms

This boils down to the fundamental of how fast you get paid, and how fast you pay people.

Here are the components of getting the best possible ‘effective payment terms’:

3) Payment Term Policy. Set target terms and minimum acceptable terms. If your business model means you can take deposits, always take deposits. The downstream effect is huge.

4) Payment Term Negotiations. Set up your sales and procurement teams to negotiate / deliver against that policy. They must be incentivized and performance managed against delivery

5) Payment Term Incentives. With the right base position from 1 & 2, you can extend incentives to move terms in your favor. This leans into the trade off between gross margin and working capital. Discounts for deposits. Early Settlement Discounts. Increased item cost for longer payable terms. Etc.

6) Rebate structures. Here's a great working capital trick. Offer customer structures with retrospective rebates, that get paid after the end of an agreed period. Do the reverse on the purchases side, trade those benefits back into net invoice price.

7) Working Capital Lending Facilities. There is now a banquet of off-balance sheet funding solutions for payables and receivables. These help manufacture a negative working capital position. But they are expensive. I don’t recommend them in mature businesses. But in a rapid growth business, it’s often cheaper and easier to get than VC funding. Useful, but use with caution. It's a helluva drug.

The final piece on payment terms, is compliance. You cannot control when you get paid. You can only influence. So your influence needs to be good. That’s collections (see below). You can control when you pay people. I recommend you are a slow, but good payer. Get the longest payment terms you can, but stick to them. It’s honorable, and good business in the long run.

Transaction Processing

Executing individual transactions with speed and accuracy is the bedrock of a finance function. Building great transactional processes is not for today. But it will be for another season.

In the meantime, here are some headlines:

8) Source Document Accuracy. If you can’t get your sales invoices right first time (or purchase orders), there is a world of pain downstream. The horror stories earlier in this post, both show how bad it can get. It will destroy your cash conversion cycle, your reporting, and your relationships. No excuse for bad process. Get it right.

9) Discrepancy Resolution. This part of the cycle is all about exception and issue management. However, hard you try, you will always have invoice discrepancies. Both sales and purchases. Having a process to identify and resolve them fast is critical. When you (or your counterparty) doesn’t get the invoice right first time, make sure it's right second time. And fast.

10) Speed to Ledger. How fast can you get transactions processed through your workflows onto the AR or AP ledger. This used to be a competitive advantage, robotic process automation could shave a day or two off your CCC. Now it’s table stakes. If you are a business that takes 3 days to raise a sales invoice, you are going to get crushed. And with the quality of software improving, and the emerging influence of AI, small businesses can access best in class automation too.

11) Collections and Credit Management. Have a robust cycle for offering credit to credit worthy customers. And then a standard routine for overdue debts. It shocks me how many businesses are lazy about overdue debts. You did the work, but the customer didn’t pay you? How f*cking dare they … In a distressed business, the squeaky wheel will always get the oil. If a distressed business owes you money, make sure you are the squeakiest wheel they have.

Inventory Management

Linked to the supply chain design and business model. How you manage inventory (or work in progress) will drive not only DIO, but your whole CCC.

Here are some key drivers:

12) Range Complexity. If you are a one product business, you have a massive advantage here. But even if not… Costco beat the hell out of any retailer on CCC. How? They only stock a maximum of 4,000 products. That’s less than 10% of your typical supermarket. Holding minimum safety levels on a long tail of products is expensive for the P&L. But it’s even worse for DIO. And smaller range = more concentrated leverage with the supply chain = better DPO.

13) Forecasting & Planning. Great inventory planning, is about optimizing for complex competing variables. Minimum order quantities. Safety levels. Lead times. Demand patterns. Different by product, and likely different by time of year too. December supply chains anyone?? Doing this well is rocket fuel for a product business. Amazon have got so good at it, they have 12 million products and still manage to have a negative cash conversion cycle.

14) Speed of Sales Cycle. Faster cycles (e.g. fresh food) need a more responsive supply chain. The quality of that responsiveness will be a huge driver of DIO. Compare that to a slower sales cycle; Aerospace. They know their demand. Their challenge is different, to get paid for Work In Progress in the right way at the right time.

15) Inventory Controls. At some point, it comes down to basics. Good physical inventory security, regular counting, rotation. If you sell a product your system thinks you have, but does not exist in the physical, that is a huge CCC inefficiency. That customer was ready to pay you, and now they can’t.

Working Capital Management is Detail

There is so much more to say on these topics, and they will all feature in future seasons.

But the key lesson is this. There are hundreds of micro decisions that go into a cash conversion cycle. You need to organize those decisions into ways that make sense for your value chain.

Make sure you are clear who is responsible, and drive the individual drivers hard and in your favor. Detail. Clear escalation levels, and a close man mark from finance.

Working capital is like water. It will leak into cracks you don’t even know are there.

Good working capital management is about filling those cracks.

Homework

1. For your business, use the earlier table to breakdown each of the 15 drivers for your working capital cycle.

2. Quantify the influence each driver has on your CCC. Rough is ok. I.e. Good vs Bad management of Collections = +/- 5 days

3. Grade your business for effectiveness on each driver from 1 through 5. 5 is perfect. 1 is terrible.

4. From here it should be easy to identify where your priorities should be. Plot each driver onto a 2 x 2. High Influence, But Low Effectiveness … that’s where your lowest hanging fruit is.

5. Get after improvements. Hard. Measure movements in CCC to know if you are winning or not. There will be real money in there if you look hard enough, there always is.

Next week is the last issue in the series; how to make cashflow the dominant language of your business.

THIS WEEK ON SOCIAL MEDIA

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Although it wasn’t even the best Beckham meme of the day. That honor goes to the brilliant Bucco Capital:

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Proper editing is one of many changes I’ll be making to this newsletter from the New Year. Watch this space for a bigger and better CFO Secrets for 2024 👀

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AND FINALLY…

Next week will be the last post of this cashflow series, and also the last post of the year. We’ll finish with a bang.

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Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need]p