Working capital optimization can yield real gains. (Financing for Growth: Special Section).

Effective management of working capital can enable companies to free cash from their balance sheet and put it to more productive use in growing their business.

With demand for commercial paper down dramatically, many CP issuers have responded in predictable fashion by tapping bank lines of credit, or, in more extreme cases, by issuing long-term debt. While such responses make sense for companies facing an urgent cash crunch, it is important to recognize their potential danger as long-term solutions to corporate funding problems.

Under the pressure of increased demand, the cost of bank credit is already starting to rise, suggesting that, over time, it may not remain the reliably cheap source of capital it has been in the past. And using long-term debt to fund short-term obligations is a classic financing problem, as well as a significant consideration for analysts as they watch how companies manage their long-term debt.

The question, of course, is what to do as an alternative. For many companies, the answer can be found on their own balance sheet. By optimizing working capital management practices -- that is, by more efficiently executing the policies and processes that impact working capital in the C2C (customer to cash), P2P (purchase to pay) and F2F (forecast to fulfill) cycles. Where appropriate, cash freed from working capital can also be used to pay down debt, buy back stock or even increase the company's dividend.

While working capital improvements won't generate cash as quickly as tapping a line of credit, companies can unlock dramatic amounts of money from their operations in surprisingly short periods of time -- with no obligation to pay it back.

A few years ago, for example, an integrated building-products manufacturer implemented a fast-track working capital optimization program that freed more than $200 million from working capital in just four months. The initiative focused on improving the company's C2C and P2P processes, which had been inconsistent among its various business units. The company also had been suffering from a near complete absence of expenditure controls, which, in some cases, had been causing it to pay suppliers ahead of terms.

To stop the bleeding, the company standardized and rationalized its customer and supplier terms, rewrote its payment and collection policies to better manage risk, linked its procurement and accounts payable processes, upgraded its systems to reflect these new policies, then instituted a measurement system that allowed management to monitor and help control cash flow. The $200 million recovered through these initiatives was then used to fund a share repurchase program and pursue an acquisition.

Of course, even more dramatic results can be achieved over longer periods. One company was able to boost its cash flow by $860 million after 18 months. Yet another was able to boost its annual cash flow by $5 billion and raise its annual profits by $300 million over two years.

The latter company did so by totally reworking its worldwide C2C processes, installing new software systems, developing a formal dispute-management process for outstanding receivables, rewarding its sales force for ensuring accurate and timely billing and giving managers new metrics that allowed them to monitor the company's progress in minimizing days of sales outstanding.

While it would be easy to conclude that working capital optimization programs are appropriate for companies in difficult circumstances, it would be a mistake to limit their application to those situations. Such programs also can be powerful accelerators for companies already enjoying strong growth. Suppose, for example, your company is generating $1 billion in sales today with $200 million tied up in working capital, and is on track to double its sales over the course of the next five years. If your working-capital-to-sales ratio stays at 20 percent, you will have $400 million in working capital by 2007.

But take action now, while the company is smaller and more manageable, to pare the working-capital-to-sales ratio to 10 percent, and you'll need just $200 million in working capital in 2007. The $200 million difference will then be available to drive still more growth.

Beyond Finance

Although working capital improvement programs are frequently led by the finance team, working capital management itself is more than a numbers game. It is, in fact, the lifeblood of an organization, touching on virtually every business process involving customers, suppliers and products. Its three components -- P2P, F2F and C2C -- are inexorably intertwined, and trouble signs that appear in one area are often traceable to processes in another.

As a result, the most effective working capital optimization programs will address all three activities. The upside is that such efforts do more than just liberate cash from the balance sheet. Because they are rooted in process-based effectiveness, they also improve a company's transaction efficiency and operating speed and reduce error, waste and rework throughout the organization. This results in cleaner transactions between the company, its suppliers and customers, making it easier, quicker and cheaper to do business with each other. In short, working capital improvement programs also improve customer service.

The reason for this is simply that the levers that most affect working capital are operational rather than financial in nature. If this seems counterintuitive, consider for a moment a company that is having trouble collecting its receivables in a timely fashion. The finance chief could blame the accounts receivable department and simply insist that they do a better job of riding herd on customers. But what if the collection problem is rooted in inventory shortfalls that are causing orders to be delivered late? What if a parts supplier is supplying faulty goods that compromise the quality of the company's products, angering customers and prompting them to withhold payments? Or what if the sales force has been quietly promising extended payment terms but not sharing that information with the collections department?

It is only by addressing the root cause of the problem that the collections problem can be resolved, and seldom is that cause purely a financial one. Fortunately, a real solution produces tangible benefits. Once the problem has been addressed, you not only reduce working capital, you also make your customers happier, more likely to pay on time, and, just maybe, more willing to give you a larger share of their business. That equals growth.

While almost no working capital problem is difficult to resolve individually, it is important that a working capital optimization program be sufficiently broad to address all of the issues in a comprehensive manner. In addition, it should reflect the evidence that good working capital management depends upon the presence of several critical factors: consistent and efficient processes, clearly articulated policies, leverage of the extended enterprise of suppliers and customers, and metrics that track performance against goals. When these are not present, companies inevitably deploy more working capital than their comparably sized peers.

Fortunately, the payoff can be dramatic. Most working capital initiatives wind up being self-funding, with returns typically equaling, and often exceeding, 10 to 20 times the investment. For companies caught in a credit crunch, such initiatives may be one of the fastest and certainly the most cost-effective way to free up additional cash.

For companies not in crisis mode, the situation is even better. A working capital optimization program can also be the best way to make sure that a bigger percentage of every new revenue dollar a firm generates falls to the bottom line.

RELATED ARTICLE: 10 Blunders to Avoid Here are 10 common mistakes companies make when they set out to improve their working capital management practices without paying attention to the need for key success factors.

1 Believing that working capital management problems can be fixed solely by the chief financial officer. Since the levers that most directly impact working capital are operational in nature, working capital optimization programs must extend beyond the finance department. Accordingly, the CEO must function less as a business unit watchdog and more as a strategic partner, balancing the diverse priorities of the company's entire managerial team.

2 Engaging in artificial efforts -- such as delaying payments to suppliers or indiscriminately stepping up collection activities -- to boost quarter-end or year-end performance metrics. In business, as in physics, every action is met with an opposite reaction. Delaying payments to vendors may reduce working capital over the short term, but that improvement is likely to disappear over time as vendors adjust their pricing accordingly. A haphazard, ill-managed collection push is unlikely to achieve any long-term results, and may alienate customers.

3 Beating the "cash is king drum" internally and to Wall Street, but not linking executive compensation to cash flow and comprehensive working capital metrics. For most managers, compensation drives behavior.

4 Waiting for a business recovery before trying to improve working capital processes. Just as growth should not be used as an excuse to ignore working capital, neither should a crisis. Doing so can significantly inhibit a company's ability to grow and meet demand once business rebounds.

5 Believing that ERP (enterprise resource planning) systems and technologies are the silver bullet for working capital improvement. In fact, large investments in ERP systems generally do not, by themselves, bring working capital improvements. Over the near-term, they actually can cause deterioration in working capital performance as key managers and employees are distracted from their daily routines and forced to fine-tune the new system. The hard truth is that ERP installations don't improve processes, but merely enable processes that need to be improved before the new system is installed.

6 Failing to connect suppliers and customers across the enterprise to gain significant, mutually rewarding benefits. Companies can improve working capital performance while treating suppliers, customers and the corporation itself as three distinct entities, but maximum benefits are achieved when business processes mirror the inextricable ties between the three entities.

7 Delaying payments to suppliers as a tactic to increase cash flow before fully exploring how your company can negotiate better terms or gain discounts for prompt payments. Once you become a late payer, your bargaining position is severely compromised. Instead, use your leverage as a prompt-paying customer to your advantage. You'll not only save more money, but retain the good will of your suppliers.

8 Reducing inventories without improving the overall supply chain process. There is a direct correlation between the amount of inventory a company holds and the level of customer service it can provide. If you reduce inventory levels too much without addressing your core processes, customer service can suffer.

9 Letting debt become overdue before identifying disputes and contacting customers to resolve them. A better practice, by far, is to contact your most valuable customers before payments are due to resolve any potential disputes. For payments that do become delinquent, develop a proactive, systems-based, event-driven procedure to resolve disputes. Assign collection responsibilities to specific individuals, and escalate that responsibility to increasingly senior employees as invoices become further past due.

10 Having a business model geared around making-to-stock when you have the capability of making-to-order or making-to-demand. "Build it and they will come" is a movie cliche, not a sound business practice for most companies. Gearing your business model to customer demand is simply more efficient and logical, than gearing it to sales projections. At companies that must rely on sales projections, develop forecasting techniques that incorporate intelligence from all relevant segments, including not just sales but manufacturing, distribution and marketing.

Stephen Payne is President of REL Consultancy Group. He can be reached at 914.539.4150 or [e-mail].