Working capital management: difficult, but rewarding.

From the perspective of the chief financial officer, the concept of working capital management is relatively straightforward: to ensure that the organization is able to fund the difference between short-term assets and short-term liabilities. In practice, though, working capital management has become the Achilles' heel of scores of finance organizations, with many CFOs struggling to identify core working capital drivers and the appropriate level of working capital.

As a result, companies can be limited in their ability to weather unforeseen or adverse events and ensure that cash is readily available where it is needed, regardless of the circumstances. By understanding the role and drivers of working capital management and taking steps to reach the "right" levels of working capital, companies can minimize risk, effectively prepare for uncertainty and improve overall performance.

Theory vs. Practice

For most CFOs, the greatest challenge with respect to working capital management is the need to understand and influence factors that are out of their direct control, in order to obtain a complete picture of the company's needs. The CFO's span of control can be limited in terms of functional silos, though corporate finance may well have some powers of influence over operating units.

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While organizations generally concentrate on the right processes, such as cash, payables and their supply chain, they are less likely to take into account various internal and external constraints that can dictate how effectively those processes are executed. For example, the legal and business environments can have a significant impact on performance. Similarly, internal considerations--such as organizational structure, shared systems, autonomous business units, multinational operations and even information technology--can impact working capital, creating barriers that can hinder a CFO's ability to truly understand, and therefore manage, the company's needs.

The human factor is another important consideration. If management is focused purely on top-line growth, insufficient attention may be applied to cash flow management and forecasting. A hard-line focus on year-end or quarter-end results can produce a flattering, but inaccurate, picture of working capital performance and lead to counter-productive behavior.

Consider the impact on working capital of a year-end sales push where production has been building up inventory (which may not be the appropriate inventory) to meet this artificial demand, and the quality of receivables deteriorates during the early part of the following year.

While there is no magical solution for effecting robust working capital management, there are a number of prerequisites for gaining control of the complex process.

Proper Forecasting

Proper cash flow forecasting is essential to successful working capital management. To do this effectively, organizations must take into account internal and external working capital drivers and consider the sensitivity of those drivers to changes in the business or market.

Various questions need to be asked: How will unforeseen events impact working capital requirements? What if a sudden market downturn or upturn occurs? What if the company loses a major customer? What happens if a major competitor takes a significant action to improve its market position? Since each of these could have a sizable impact on the business, organizations must assume that the only certainty will be uncertainty, and prepare accordingly.

In addition to assessing the cash flow impact of potential events, companies should consider the possibility of having to make additional working capital investments. That's because events could affect non-operational cash requirements such as investments, credit ratings and the ability to service debt, as well as inventory, payables and receivables.

Companies must implement contingency plans that take a holistic view of the organization in the context of a variety of different challenging situations. This will help minimize the adverse effects of unforeseen events and provide financial flexibility in uncertain times by having working capital as a ready source of cash.

How can you manage uncertainty? The three fundamental approaches are: control it, predict it, react to it. The most successful approaches are based around one approach, but contain elements of all three. Market-leading companies, perhaps not surprisingly, are in the best position to manage uncertainty, often enjoying the ability to control supply, minimize inventory and apply payment pressure on customers.

Companies with less influence, however, must rely more heavily on a strategy of prediction. To properly prepare for events and improve or maintain performance during times of uncertainty, organizations must develop an objective, business-driven view of the role of working capital. Without real insight into true working capital drivers, a company may be able to produce a reasonably good consolidated forecast, but find that accuracy drops considerably when it comes to producing divisional, operating unit or even a product-line forecast.

The most effective programs for both improving working capital performance and forecasting are those that look beyond the local organization and consider the broader corporate environment. Corporate investment and financing arrangements, for example, may provide for cash to be delivered by one location, but utilized at others. Restrictions on the repatriation of cash, internal inefficiencies in moving cash, delays driven by banks and sometimes-inadequate access to information can make the process problematic.

Cash generated in one country, for example, many not have the same value to the organization as cash generated in another. As a result, companies must plan global working capital improvement initiatives in the context of the ultimate use for the cash, rather than simply managing local balance sheets.

Setting the Stage

Successfully improving working capital management requires a multipronged approach. Companies must seek granular detail to identify the underlying drivers of working capital. This requires separating perception from reality and pinpointing impediments to efficient cash flow, such as poor links between production and billing or clumsy treasury operations.

Companies must also adopt an entrepreneurial mindset. They must act quickly to drive change by combining operational and financial skills, and expand their thinking beyond the finance organization to gain a more complete view of overall operations. Rather than wait for the perfect solution, they must identify and implement strategies that result in quick wins, generating short-term cash to fund longer-term projects.

Having the right people in place can also make or break the effort. Companies need to identify individuals who can be responsible for setting targets and performance levels and be held accountable for delivering. These professionals should be encouraged to challenge the status quo and drive change, using cross-functional teams.

Finally--and this is where many projects fail--companies must remove emotion from the analysis process. All initiatives must be business-case driven, and projects without measurable results or those not contributing to overall goals should be abandoned. Companies must agree on success criteria, prioritize based on contributions to these criteria and continuously measure performance.

While working capital forecasting is critical to a company's ability to make informed strategic business decisions, many CFOs struggle with the process because of a lack of control and real insight into the underlying drivers of their working capital needs. By empowering the entire organizations to understand the company's true working capital needs, companies can successfully reduce their financial risk, prepare for uncertainty and create a ready cash reserve that will provide flexibility and security during difficult times.

Andrew Harris ([e-mail]) is a United Kingdom-based Senior Director with Alvarez & Marsal, a global professional services firm. He specializes in performance improvement and working capital initiatives at companies throughout Europe and the U.S.