Solvent after the crisis

More liquidity through working capital management

by Michael Betzien, Partner, Kerkhoff Consulting

The crisis is over; demand is increasing again. Yet, many companies have problems to provide the liquidity required for the economic upswing. Because to be able to meet orders on time, inventories must be built up and production kicked up. Efficient working capital management will strengthen internal financing required for it at the companies. When optimization extends along the value-added chain – in purchasing, in production and in sales – a company's  tied up capital can be significantly reduced and its liquidity thereby increased by 20% to 30% on average.

Purchasing: Inventory and payment management
Inventory management is an important leverage for working capital reduction in purchasing because inventories are generally the biggest item in current assets. One major objective is to reduce the procurement time for goods so that companies can flexibly react to ordering and price fluctuations without the need to build up high inventory reserves. Various measures are helpful in reaching this goal: First, close connections to the supplier in terms of information ensure that fluctuations in demand can be met on time. A special characteristic form in this respect is the supplier-controlled inventory, where the supplier controls and stocks the company's warehouse. Second, just in time deliveries can bring about a synchronization of supply and demand.

Then, production only needs to store the material required for manufacture. Storage by the enterprise will thus be inapplicable. Additionally, strategic supplier management helps keep inventories low and reduce stockout costs. Concerning the selection of new suppliers, detailed evaluations should be used beforehand already and collaboration legally secured. Companies can thus prevent that, in case of early supplies, they would also have to pay sooner.

Another decisive factor in reducing tied-up capital is the optimization of payment terms. From the viewpoint of an individual company, an extension of the time allowed for payment towards the supplier will principally have a positive effect on the company's liquidity since it results in a reduction of the cash conversion cycle. Costs could also be saved through more specifically selective collaboration between the company and its suppliers. For example, if the ordering company has a lower capital cost rate than the supplier, the time for payment may be reduced and the company, in turn, obtains a price reduction from the supplier.

Production: Reduction of throughput times
In production, various interacting measures have a direct effect on working capital. The reduction of throughput times allows the company to react more flexibly to customers' demand and do without high inventory levels to be able to meet fluctuations in demand. A lot of time and money can be saved especially with regard to the setup times of machines because production is stopped while work is being done on a machine. Thus, a reduction of setup times by 50% – e.g. by so-called external setup – will also allow a reduction in lot sizes by up to 50%. This allows higher flexibility in production. Customer demand can thus be responded to more closely, and the company will produce only what is really necessary. At the same time, safety reserves and fluctuation inventories will be reduced in production.

Furthermore, route optimizations can save time – this not only during machine setup times but also during overall production. To this end, production is divided into sections and newly arranged by sensibly rearranging the machinery. It is frequently recommended to establish a U-shaped production cell to keep the path between all machines as short as possible. Production control also has a major effect on its stock levels. Decentralized control is able to influence the flow of material at specific points with the result of flexible production. Thus, production controls itself through the demand at specific points, and high stock levels will not build up.

Sales: Implement accounts receivable management
Working capital can also be reduced in sales. Selective accounts receivable management ensures that customer payments will be received within the shortest possible period of time. This is realized, on the one hand, by optimizing the billing process and the dunning system. Implementation of an electronic solution can significantly simplify and standardize the processes. By establishing a trust relationship with the customer, the company will achieve, on the other hand, that the customer swiftly pays invoices – for example, by continuously ensuring the quality of products or by always meeting the delivery periods. It is also recommended to allow the customer a discount through reduced times for payment. In this case, it should be calculated beforehand whether the profit from the reduced time for payment is greater than the loss in sales due to the discount.

To principally prevent any loss of receivables outstanding, customers must be checked for their credit standing prior to entering into business relationships. A legal basis for calling in the invoice amount can be established by laying down the payment terms in General Commercial Terms and Conditions. Another possibility is to deliver goods only against cash in advance. Another customary procedure is to sell receivables outstanding to a factoring company. Here, the so-called factor immediately pays the amount of the receivable outstanding minus a fee and interest rate. In turn, the factor will accept all delinquency risks. Here again, the company must carefully consider whether profits will be higher due to the faster receipt of payments than the fee to be paid for factoring.

If selective measures interact along the supply chain, companies will be able to save a lot of money through optimized working capital management. It supports internal financing and, in a best case scenario, it can make the business independent from outside lenders.