Working Capital Magic - From Customers to Cash Flow

SOX Compliance in Credit & Collections

A lot of folks are focused on SOX (Sarbanes-Oxley) compliance.  And some of these folks are actually the companies trying to go through the SOX compliance process.  The fact of the matter is that there are a myriad of companies out there looking to sell products or services around meeting SOX requirements.

Now, I think that although automation software and audit & compliance services are important, companies really need to look at different processes within the enterprise to accurately judge what they need.  Many times, improvements in their internal business processes can go a long way towards achieving compliance.  Today's post is going to focus on setting up internal controls around the accounts receivable, credit & collections functions.

Although all of this rolls up into a COSO framework (stay tuned for a future posting), some of the things that are critical to address are identifying controls and ensuring testing of these controls for every aspect of the Customer-to-Cash process:

1. Order Processing: You need segregation of duties in the order entry and management process.  Many times, this can be set up in the ERP system with authorization levels for different transactions

2. Accounts Receivable: many things need to be controlled here, but specifically credit memos and write-offs need to be only authorized by appropriate management approval.  Additionally there have to be segregation of duties in different functions of A/R

3. Credit Management: you probably shouldn't have the same folks assigning credit limits as those applying cash and performing post-payment activities.  More and more companies are looking to segregate, monitor and control these activities

4. Cash receipts: cash application from the lockbox has to be as automated as possible (it helps your hit-rate too).  Additionally, a set of reconciliation acitivities have to take place between payment transactions and the banking records.

Finally, you have to have a reat internal control plan, documentation, test plans and a remediation plan when infractions occur.

Its pretty clear that process changes have to go hand in hand with technology and personnel training for companies to be successful in their SOX compliance efforts.

Cash Forecasting and Price Volatility

In many industries, including those dealing with commodity goods, pricing changes are rampant and can make generating an accurate cash forecast especially difficult. The only way to deal with these fluctuationsis to have a solid cash forecasting methodology to address the dynamic nature of pricing changes, customer payment habits and changing business conditions.

The best approach for cash forecasting will focus on defining a reasonable scope and an appropriate level of precision. This in turn will lead to being able to easily compare actuals to forecast values and determine variances.  The challenge is to easily access distributed financial data in a timely manner, store historical cash flow data for trend analysis and allow simulation of multiple cash forecast revisions based on multiple sources of input. These sources of input could be individual collector information, promises-to-pay from customers as well as historical payment data.

When dealing with pricing changes, you need to identify trends and cycles from the past and apply them to the cash forecasts. If pricing changes are seasonal, for example, the reflected payment history can be taken into consideration while generating the forecast. Similarly, each forecast revision can be updated to reflect other criteria such as known projected pricing changes, thresholds set by collectors, etc. In this manner, simulations of different forecasts, along with realistic acceptable variance levels, can bring a higher level of predictability to cash flow processes.

Short term cash forecasts based on receipts and disbursements are even more powerful when you go beyond billings and vendor invoices - the real power lies when you take into account anticipated events on the supply and demand side.  More on this later...

Data Diving: The Fine Tooth Comb

This is my first post of 2005.  Happy New Year!

It's always great to talk to senior V and C-level executives to get the 30,000 foot level view of the world.  And you just can't get a better feel for the trends and market forces shaping the industry and their impacts on the business.

But the key challenge is to then delve into the details of those business trends and understand how they affect business processes, individuals and the ongoing trajectory of a company's performance.  This is where diving into business data becomes invaluable. 

In my experience, getting and analyzing business data is an art.  Take customer segmentation realted analytics.  Even though there are a host of CRM solutions that help examine different customer based performance activity, the trick is to first figure out what you need to look at.  As an example, we can look at customer segmentation with respect to different working capital processes:

(You can read my previous posting on Customer Segmentation to Manage Working Capital Risk to get a better background on what I'm talking about).

Some key data elements to look at are:

1. Customer payment history over time - DSO by customer, average days late, average time to pay, broken promises to pay, etc...
2. Customer level inventory metrics - Inventory Turns, % of spend attributed to specific customers, if possible, excess & obsolete inventory by customer...
3. Forecast and demand changes/variations over time per customer
4. Customer level credit scoring, both for new and existing accounts
5. Revenue segmentation by customer and customer region, gross margin by customer

and it goes on and on and on...

I also like the Gross Margin Return on Investment calculation that a lot of retailers use to plan and measure their assortments.  One great thing about this is that it gives a great view into which customers and products to protect, which to nurture and grow and which to prune from the portfolio. 

Again, having the right data is key in any type of analysis.  Specific to working capital management, I'd recommend keeping in mind the following:

1. Remember that working capital data is often strewn around the supply chain - account for different data sources, different trading partners, different global regions, etc

2. You have to have a representative sample of historical data to analyze.  For example, if you are aalyzing an A/R portfolio, you need to get at least a year's worth across multiple business lines.  This helps to identify cyclicality in payments, billings, etc..  Also you can slice and dice the data to see the effects on different operating theaters

3. Oftentimes, the important parts of the data analysis is seeing what is not shown.  Although many people might disagree, I think if you're cofortable with your data integrity, you can do some correlation and estimate whether you assumpations about working capital operations is true.  For example, if you were analzying revenues for a CPG (Consumer Packaged Goods) company, you may expect to see a great deal of seasonality in revenues.  However if the data does not point tot his situation, you can then dive into the root causes - maybe deductions are higher due to New Product Introductions, complex promotions, slotting fee hikes, etc...

It's helpful to keep an open mind to possibilities and think outside of the box when really trying to infer business knowledge from a stream of data.

Maximizing Cash Conversion Efficiency

Maximizing cash conversion efficiency is a fundamental part of better working capital management.  The cash conversion cycle is a great measure of how companies manage their receivables, inventory and payables and transform them to liquid assets : cold hard cash.

Focusing on the full working capital cycle is where companies can find opportunites to maximize their free cash flow.  Emagia provides software that allows companies to manipulate their cash flow levers to drive significant performance improvements and increased cash conversion efficiency.

A couple of thoughts on the cash conversion cycle:

1.  Having a negative cash coversion cycle is a lot easier when your company is at the downstream end of the supply chain (e.g. Cisco and Wal-Mart).  This isn't the only factor, but it certainly helps

2.  Being as close to the end consumer demand is critical to drive inventory efficiencies.  Again, this is a factor of being the downstream end of the cupply chain

3.  Being the 800 lb. gorilla in teh chain is a big factor.  Retailers command the actual distribution and can therefore squeeze their suppliers as much as they want.  In addition, they have little in the way of actual receivables (based on credit card type consumer transactions).  Also, they force their suppliers into VMI or consignment oriented inventory management practices, thereby diminishing their inventory liability

Another example is Cisco during the dot-com boom.  Cisco was clearly in a sweet spot where demand for telecom products was initially far outstripping supply.  And their suppliers were scrambling to fill up the pipeline and were more than willing to extend elongated credit terms.  So the negative cash-to-cash cycle was easy to attain.  It probably didn't hurt that the economy had bouyed the suppliers and well as Cisco's customers into a cash-rich status.

An interesting study would be to look at different supply chains across various verticals and see where the 800 lb. working capital gorillas are...

Quick Response Manufacturing & Replenishment

Back in the day, when I was hard at work in the factory, I learned a very valuable lesson about the difficulties of manufacturing and supply chain operations.  The top three challenges of running production and distribution companies that I learned are:

1. The forecast is always inaccurate
2. The forecast is always inaccurate
3. The forecast is always inaccurate

And unless you have a magic crystal ball, the typical way companies mitigate this risk is by stocking up on inventory.  It doesn’t take a rocket scientist to understand how horrific this is, especially when your company offers a wide variety of finished goods.

So the way we addressed this issue is by emulating the leading supply chains and focusing on the three following concepts:

1. Reduce lead time to negligible amounts if possible
2. Build a flexible manufacturing & replenishment process
3. Drive down the cost of goods sold as much as possible

When I had responsibility for manufacturing and production scheduling, my number one concern besides hitting on time performance targets was minimizing finished goods and WIP inventory.  Although we have rolling monthly forecasts from our customers, the variations in demand were astounding and often spikes would occur unexpectedly.  And since we were a turnkey supplier for high tech OEMs, inventory lying around the shopfloor was easily visible to management.  This was especially true in our sheet metal fab (Ever try to step around a metal fab plant piled to hilt with rusted blanks?  Not pretty).  The printed circuit board inventory was extremely costly as well, but due to the comparative size, it could be hidden around the plant pretty easily.  (That is until the QBR, when we had to review the age of our board builds and ASIC inventory).

So I first concentrated on identifying bottlenecks in the sheet metal fab where WIP could build up and go stale.  In our case, the forming process and the operations feeding it were causing a lot of buildup and quality issues.  A lot of times, the preceding operation, which was punch pressing different shapes from sheets of cold rolled steel was not properly tied to changes in demand (meaning MRP wasn’t being regenerated frequently enough).

The answer was in implementing Quick Response Manufacturing & Replenishment techniques.  The highlights of this approach included:

1.   Running MRP more frequently with net changes for specific product lines

2. Production scheduling of punch press operations closely ties to MRP
3. Applying a nesting software to maximize the yield of the punch press operation while also reducing cost per part produced
4. Tying in a pull-based Kanban process to the MRP run.  Keep in mind that this was before we investigated using Advanced Planning Systems based on the Theory of Constraints

The lead time of dropping a production order to the floor to replenishing the OEM’s consignment stock was dramatically decreased.  Not to mention the WIP levels throughout all operations across the plant.  And best of all, we were able to improve on-time performance.  I’ll post the details of the approach as well as how the Quick Response Manufacturing & Replenishment program worked along with the graphical changes in WIP inventory.

Liquidity Management - the Process of Multi-Lateral Netting

Global corporations that span multiple business units tend to have a big mess of inter-company transactions to clean up.  Not wanting to spend a lot of time, money and effort on individually carrying out reconciliation, a lot of companies rely on netting centers.

Multi-lateral netting is the process by which buy/sell transactions between different operating units in a company get settled.  Typically, one unit may be buying (generating payables) from another unit while at the same time selling (generating receivables) to this same unit.  At the end of the day, there are numerous complexities with foreign exchange exposure, float management, and inter-company receivables that need to be addressed.

The costs of these inter-company transactions extend from cross border flows, to redundant banking charges to currency exchange fluctuations.  On the other hand, I don’t know if there is a lot of benefit to be gained from inter-company transactions – they’re just a cost of doing business.  The key is to use multi-lateral netting to reduce this cost across the company.

The netting cycle is a key component of liquidity management.  If carried out properly, the savings can be substantial and also drive improvements in global cash forecasting.  At a high level, the netting cycle follows this process:

1. The trading business units send their transactions over to the netting center.  For example this would be the receivables, payables, and backup documents (inter-company Purchase Orders and Sales Orders)

2. The netting center reviews all sent transactions within a fixed time period.  These are then process further in the cycle

3. The netting center uses currency exchange rates to a common currency.  Since the two business units could be in different countries, this is an important step

4. This common currency (indicative rate) tries to be in line with market fluctuations, but is not always 100% representative.  These variances need to be taken care of during the full iquidity management fucntoion.  This idicative rate is used to normalize all buy/sell transactions for the participating business units and then the “netting” process occurs.  The result is the net payment or receipt per business unit

5. Based on the netting cycle period, the netting center notifies each business unit when their payment or disbursement will occur.  In addition, taking into account the currency rates, a decision is made on how much the net payment or receipt is for.

6. The netting center then contacts the banking institution and spot buys or sells its currency surplus or shortfall to cover the transaction. 

7. The settlement occurs where the netting center appropriately carries out the net transaction between the participating business units

I’m going to talk about the benefits of this process next and also some of the challenges of dealing with the FX exposure.  Also, the netting schedule is clearly a factor that needs to be taken into consideration during cash forecasting.

Sarbanes-Oxley and Working Capital Management

Sarbanes-Oxley (SOX) is still a hot topic on the minds of companies today.  I read this interesting blog to keep up to date on the latest developments - Inside Sarbanes-Oxley.  The focus that SOX is placing on certification of financial statements is definitely trickling down to the cash flow statement and working capital management.

Particularly, Section 404 which deals with having a strong set of internal controls.  Since A/R, A/P and inventory are key drivers of cash flow, these are being seen as prime candidates for testing and process automation.  Especially A/R and off balance sheet inventory liabilities. 

Accounts Receivable is where the rubber meets the road in terms of realizing (not necessearily recognizing) revenue.   Here is where the controls have to ensure that all the cash processes - credit scoring and risk management, collections, cash appliciation are being handled in a non-fraudulent manner.  Lots of companies are putting in clear protocols and remediation processes around these functions.  In fact, a firm wall is being placed between the people extending credit to the people actually handling the transactions to prevent any type of collusion or fraud.

There's a lot more to be said about SOX and cash flow, along with Off Balance Sheet Inventory Liabilities.  As deadlines approach, companies are still scrambling to meet requirements...

I'll be posting about the COSO framework next, which helps encapsulate the solution to these challenges.

Making Sense of Accounts Receivable Metrics

I know I’ve talked a lot about delving into Key Performance Indicators for working capital management, especially A/R.  It’s great when companies benchmark internally and externally to look for ways to improve their businesses.  However, it’s also important to keep a few things in mind when you do this:

1. Deriving a global DSO figure from publicly available financial statements can be misleading.  After all, global companies typically have different terms and trade practices in different regions around the world.  So the aggregate DSO calculated from the SEC filing, might be skewed by DSOs extended by 100 days in East Asia.  So when this is compared to industry benchmarks, this may look like a dire situation, but in reality the region specific DSO may be right in line with the average.  Metrics need to be compared to reasonable benchmarks for industry, region, etc… not always a global benchmark.

2. Take a portfolio view of your A/R balance.  Some key measures to look at are % A/R current (within terms) and % A/R beyond 90 days.  It’s pretty much a given that if your receivables go long past 90 days, they are in serious jeopardy of being written off.

3. Collections Effectiveness Index (CEI) is one great measure of your credit and collections team’s productivity.  It shows how fast your collectors are converting outstanding A/R to cash. 

4. Look at DSO in the context of the complete Cash-to-Cash cycle.  Working capital gets tied up in the nooks and crannies of your company’s cash cycle.  Viewing DSO in comparison to Days Supply Inventory and DPO will give you an idea how your cash flow is materializing.  Also, some key insight can be gained by comparing average A/R balance to sales for a specific time period.  This helps to gauge your company’s cash conversion efficiency.

Bottom line: There are a lot of A/R metrics to examine and they can all be helpful.  Just keep in mind that in order to fully diagnose your company’s cash flow condition, you may have to look at multiple metrics and come up with a composite assessment of working capital management.

CIOs and Working Capital Management

Just as centralized and line-of-business finance departments are being seens as strategic players in the corporation, the same is also being considered of IT.  I remember during the 90s and through the dot-com boom how IT was driving a lot of the business decisions and corporate initiatives (anyone remember Y2K?).   Unfortunately what happened back than was that the time pressures to bring about innovation was perceived to be so critical, that IT solutions were brought in without having a fully thought out change management plans tied to business drivers.

The end result - tons of expensive shelfware.  Ask yourself how much supply chain software is out there either not implemented or poorly implemented. Or e-commerce applications, ERP upgrades, etc..

So as a reaction, the last few years have seen very little IT spending from wary corporations.  Now, with new initiatives such as Sarbanes-Oxley pushing business-driven compliance requirements, IT and its CIOs are back in the spotlight.

I think CIOs will be next change agents of working capital management initiatives.  This article from Computerworld  about the New IT Leadership Agenda  clearly points to CIOs being the standard bearers of initiatives like Six Sigma, Sarbanes-Oxley, and process change activities.

Some things to consider:

1. IT departments will definitely be judged on feasibility and ROI of any selected software solutions.  This means payback better occur within 6 months or less!

2. With the currect risk adverse climate, software costs better be "on-demand" and sold as a service.  Here is where a hosting model for software comes in handy complete with subscription services for pricing.  As an example, Textron chose to deploy working capital solutions from Emagia by using a hosted model - this limits Textron's up front investment and ongoing total costs of ownership (e.g. hardware/software/personnel maintenance and support).  It's a harbinger of the future way that companies will buy and deploy software.

3. Business users and IT will be working much more tightly together than ever before.  Look atteh ramifications of Sarbanes-Oxley: process changes have to go hand in hand with software solutions to ensure compliance. 

4. My prediction is that IT budgets will diminish - but budgets for business units will increase to reflect the need for IT spending on business applications.  However, this clearly means that the business units will ultimately determine whether applications are purchased. In turn, the burden will be in the business units to ensure that the ROI materializes, making the entire transition very fair. And this makes perfect sense for business applications.

A Portfolio Management Approach to Shared Services & BPO

I found this article on the current state of Shared Services & BPO very interesting. While it talks about the fact that companies are still unsure about their strategies to employ SSCs (Shared Services Centers) and BPO, it is clearly a topic being highly debated. Some of the things I found interesting and validated by outside sources were:

1. Executive level support is still the critical factor for success. This was cited in front of the more obvious things like SLAs, contractual agreements, training, etc... were not sufficient by themselves to drive success.

2. The need to drive a corporate governance model in conjuction with SSCs and outsourcing was seen as critical. This must extend beyond just internal controls for Sarbanes-Oxley compliance. Basically, it's about having global visibility and control over multiple trading partners in the Financial Value Chain.  (I wonder how this affects exisiting banking relationships?)

3. The portfolio approach is clearly where companies are headed - Using a combination of insourced SSCs, and outsourced BPO providers to get the job done. My personal opinion is that when it comes to cash flow processes, follow the old maxim - Control the strategic core, Contract out the context (non-core). So when it comes to A/R for excmaple, the high volume, low value transactions with the mom-and-pop customers should be outsourced while the key customer relationships can be closely held within the company. I'll have some facts and figures around this approach in a future post

4. Finally, the need for disparate system integration is clear: The top three challenges to making a global shared services approach work in the real world from a technology perspective were managing ERP systems (34.6%), knowledge management (28.8%) and workflow and imaging tools (28.8%)