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Reducing the cash conversion cycle through effective working capital management.

The global economy continues to recover following the Great Recession, and with it, the treasurer's strategic value to the organization is evolving toward efficiently managing working capital, to meet the expanding liquidity needs of their growing companies.

The question "where's my cash?" was, of course, top of mind for the vast majority of CFOs and treasurers during the financial crisis. However, as many organizations have continued to accumulate record cash balances since then (corporates' cash holdings increased 78 percent from 20082013, compared to just 27 percent from 2000-2008), treasurers are not only tasked with safeguarding cash. There is now also a common mandate to become a more strategic business partner, to ensure corporate free cash flow and liquidity goals are realized.

With many U.S. corporations currently facing the challenge of large offshore cash balances, a renewed focus on strategic cash flow forecasting has accelerated in corporate finance departments throughout America as they attempt to meet their domestic financial obligations without taking on additional third party debt or repatriating offshore cash (with the tax implications). As a result, working capital management has become the key focus for CFOs to challenge their treasury, FP&A and corporate controller teams to minimize the working capital cycle and therefore improve free cash flow.

Simply put, working capital is the liquidity available to the treasurer to satisfy their company's short-term financial obligations--i.e. current assets less current liabilities. Put another way, by optimizing the various working capital components, treasurers can reduce the cash conversion cycle, which is the amount of time cash is tied up in working capital. The cash conversion cycle is comprised of days inventory outstanding (DIO), days sales outstanding (DSO) and days payables outstanding (DPO). As global economic growth slowed during the great recession, many corporations experienced working capital surpluses, as inventory levels declined, DSO metrics stabilized, and global cash balances increased. In recent years, as the global economy has started to return to growth, treasurers are tasked with proactively managing working capital as businesses expand into new markets and geographies, which can lengthen the cash conversion cycle by extending DSO and DIO. As an increasingly strategic corporate finance function, treasury has a unique opportunity to work across multiple functions to drive working capital initiatives, track their effectiveness and positive impact to free cash flow.

Before initiating any working capital initiative, it is critical to collaborate cross-functionally to understand what implications a new working capital solution may present to the underlying business and its partners. Although the cash flow benefits of reducing the cash conversion cycle are clear from a treasury perspective, it is important to recognize the components of the cash conversion cycle and how working capital optimization programs could impact the underlying business. The goal, of course, is to minimize the cash conversion cycle by reducing DSO and DIO, while increasing DPO. However, if the focus is to improve any one of these metrics in isolation, there may be negative implications to other parts of the business. Inventory management --specifically reducing DIO--is a good example of competing priorities between the treasury and sales teams. Higher levels of inventory may be important to the sales team to ensure they can meet demand, and not forego a new sales opportunity. However, from a treasurer's perspective, a growing inventory balance and DIO will have a negative impact to working capital, and ultimately free cash flow.

One component of working capital that has been the recipient of significant innovation in recent years is accounts payable and extending the company's DPO. Accounts payable is the working capital component over which corporate finance has the most control. However, treasurers must take an internal leadership role to educate and influence their corporate finance colleagues of these benefits given corporate functions have a tendency to operate in silos, where specific departments' objectives can be contrary the overall strategic benefits to the company.

Utilizing their leadership roles, treasurers can educate their finance colleagues of the strategic benefits of an effective working capital program, which include improving free cash flow and securing internal low-cost funding (improved working capital being the lowest-cost source of cash). these groups include accounts payable, procurement, legal and the broader treasury team. Historically treasurers and accounts payable managers could delay payments to suppliers as a taxing method to extend DPO. the negative implications of this approach are apparent however, mainly stressing relationships with key suppliers and the resulting volatile cash flow levels within the quarter.

Most recently, supply chain finance and related technology solutions continue to be an effective working capital tool to extend DPO. In a supply chain finance solution, corporations with strong credit ratings can often extend payment terms to their suppliers by involving a financial institution into the solution. Under a supply chain finance solution, the supplier receives an accelerated, but discounted, cash receipt at lower effective rate than they could finance externally, while the corporate is able to delay its payable to the financial institution and thereby improve its DPO. Under this solution, the treasurer has extended the DPO, reduced the cash conversion cycle and improved free cash flow while maintaining good relations with the supplier.

Treasurers, as safeguards of their company's global cash and short-term forecast, have the responsibility to accurately monitor the future liquidity demands for their company. Treasurers can use this intelligence to align working capital and strategic cash flow plans against actual performance within the current quarter. Effective working capital solutions, including supply chain finance programs, can be strategic toolsets that enable the treasurer to proactively improve working capital, reduce the cash conversion cycle, and ensure short-term liquidity demands are satisfied and quarterly cash flow targets are achieved.

Greg Person, Global Vice President of Presales, Kyriba
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Copyright 2015 Gale, Cengage Learning. All rights reserved.

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Author:Person, Greg
Publication:Treasury & Risk
Date:Mar 1, 2015
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