Strategy

Are Your Cash Flow Improvements Sustainable? Get More out of Your Balance Sheet

By Mark Kissman
 
Cash from operations is the lifeblood of organizations and many companies continue to make improvements to managing their overall working capital.  But when examined closely, large companies’ working capital performance is often not as stellar as their balance sheets suggest. This false sense of progress could result in financial executives facing a liquidity bind when it’s least expected.
 
A popular measure of healthy working capital -- and one followed closely by the investor community -- is the Cash Conversion Cycle (CCC). The CCC is a measure of the net working capital metrics and is calculated by: DSO (Days Sales Outstanding) + DIO (Days Inventory Outstanding) - DPO (Days Payables Outstanding) = CCC.
 
If you just look at the broad metric, financial executives are only getting better as companies are able to quickly convert resources into cash flow. According to the 2017 CFO/ Hackett Group Working Capital Scoreboard, CCC for the top 1,000 non-financial companies fell in 2016 over 2015 by 1.4 days to 35.7 days.
 
But, once you look past the headline numbers and under the hood of the balance sheet, not all is as it seems.
 
A Rising Tide Lifts All Cash Boats
 
So why worry about cash when there seems to be so much of it on balance sheets?
 
First, with sales in the global economy relatively healthy and the cash to pay receivables plentiful, an improvement over a very mediocre performance in 2015 was almost expected. And despite the downtick in days, the CCC in 2016 was still relatively high. It was at nearly the same level in the depths of the Great Recession, when banks pulled company credit lines and businesses put off payments to suppliers in order to stay liquid.
 
The second reason the overall CCC improvement invites skepticism is that the trends in the components of working capital — DSO, DPO and DIO — are actually disconcerting. There is degradation in DSO performance, a slight deterioration in DIO and a long term improvement in DPO.
 
In fact, the improvement in cash flows can be attributed to a relatively healthy global economy that is driven largely by an improvement in DPO – stretching payments to vendors.
 
You can see the rise in DPO for the S&P 500 for the past five years below.
one-(1).png 
In short, companies were less efficient at managing their inventory and receivables in 2016, but they took longer to pay their suppliers.
 
In addition, while the median statistics for each industry generally improved, the laggards in each industry showed significant differences to the best in industry.
 
For example, in pharmaceuticals, the best in industry averaged a CCC of 69 days while the worst in Industry averaged 265 days.
 
This diversion occurred while the average CCC for the pharma industry increased over the past three years.
two.png
 
For one of the worst in the pharma industry, its DIO deteriorated 7% from 2015 to 2016. That means cash is being burned at an amazing rate. Each day of DIO represents almost $25 million in cash therefore the increase in inventory used approximately $350 million in cash.

While there are many differences in any best/worst businesses that drive the disparity in CCC, there clearly is a huge opportunity for improvement at many companies.
 
Follow the Data
 
When trying to understand your true cash flow, there are several data points within the cash conversion cycle that that financial executives should follow closely:
 
Days Sales Outstanding
 
  • Monitor/report deviations from credit policies – e.g. ‘no shipments to customers with balances greater than 90 days past due.’
 
  • Identify patterns on customer acceptance times to actual payment dates,
 
  • Correlate >90 day customers to Return Material Autorization history to identify product quality issues.
 
  • Track customer disputes for incorrect invoices and related processing delays.
 
Days Inventory Outstanding
 
  • Monitor/report differences in actual stocking levels compared to target levels
 
  • Track vendor delivery performance and incoming quality
 
  • Correlate manufacturing efficiency to stocking levels
 
  • Track actual unit shipments to sales forecast
 
Days Payable Outstanding
 
  • Monitor deviations from preferred vendors/ terms
 
  • Track payment terms for critical suppliers
 
  • Track vendor usage of supplier financing or offering prompt pay discounts
 
  • Correlate customer payment trends to align vendor payments – e.g. pass on the delay
 
The Takeaway
 
Tracking performance and monitoring policies are keys to improving operational results and cash flow. Unfortunately, most organizations have multiple applications to deal with critical transactions for everything from inventory, manufacturing, sales, and human resources to finance, supply chain, and more. Managing performance within a single application can be challenging enough. Imagine the scale and complexity across dozens of enterprise applications with thousands of users and multiple lines of business.

Real-time tracking and monitoring brings tremendous benefits to virtually every enterprise. By ensuring that policies are implemented and followed and that internal and vendor performance issues are quickly identified and addressed, businesses can confidently project and improve cash from operations as well as other financial and operational results.
 
FEI Member Mark Kissman is the CFO of Greenlight Technologies and can be reached at mkissman@greenlightcorp.com.