The Risks of Working Capital Optimization

To counter the impact of the current macro-economic distress triggered by the 2008 financial crisis, corporate treasurers have been challenged for the last 5 years to optimize their company’s working capital.

The major components of working capital are: accounts receivables (AR), accounts payables (AP), and inventory. Cash is still king and the decisions and actions undertaken to obtain it require the strict reduction of the company’s working capital. This however may sometimes lead to unintended negative—and counterproductive to the company’s business—consequences. Let me elaborate this concept.

To optimize working capital a treasurer must:

• Reduce AR
• Increase AP
• Reduce Inventory

If these actions are performed in isolation chances are that the results obtained will dramatically backfire and resolve in deteriorating relationships with both suppliers and customers. That is, to jeopardize the whole business of the company. In fact, if we look at the techniques frequently adopted by companies to increase accounts payables we find abundant literature of (unfortunate) stories about companies that decided to pay late their suppliers, when not even to simply suspend payments until further notice. Another usual tactic to optimize working capital is to make the supplier hold inventory and deliver only what strictly needed for the production cycle. This unfair practice is often cloaked with an aura of “collaborative” or “on demand” supply chain management while—in effect—aims at bluntly pushing costs back to suppliers.

Such strategies steadily produce financial distress to the supplier and enhance the risk of its failure, and—in return—negative consequences to the buyer. Besides being insane, this strategy is also myopic as it doesn’t consider another important factor: The importance of ensuring supplier loyalty. In a globalized market a supplier is serving not a single client but a network of clients that are very likely competing against each other. So if a buyer is forcing that supplier to bare all the costs of the supply chain, chances are that the supplier will opt to loosen the relationship from the imposing client and prefer to work more for the others. A disloyal supplier soon will turn into a supplier that will make very little efforts to adapt to changing requests. If that supplier provides key components (i.e., it is a “strategic” supplier), its lack of agility will make the buyer less flexible to adapt to market changes. And a company that cannot adjust to market changes will soon be out of business.

The situation on the AR side is not different either. One common adopted practice to reduce AR, in fact, is to improve the collection of receivables by tracking aging credits and soliciting late payments from customers. What happens, though, to a company if such collection processes are not executed in a harmonized manner among the various departments? E.g., what if a solicitor in the accounts receivables department chases a customer for a presumably unpaid invoice only to discover that the delay had been agreed between the customer and the sales account? Or—after having threatened the client with a legal dispute action—to face the fact that the amount of the late payment is minimal vs. the potential revenue sitting on a large contract that same customer is about to sign?

Don’t get me wrong. Working capital optimization is indeed a best practice that corporate treasurers must strive for, but other factors must be considered to mitigate the risk of backfire: The attention to supply chain risk and liquidity management. Let’s discuss each separately.

Supply chain risk: Responsiveness, reliability, and flexibility are indispensable performance attributes that participants in the supply chain must reciprocally exchange to ensure streamlined operations and profitable results. Suppliers, distributors, freight forwarders, import and export agents, warehouse operators, and outsourcing partners, are but few of the many participants and nodes of vast supply networks. Before each one embarks on actions to optimize their own working capital ratio they should look at the bigger picture to avoid likely negative domino effects.

Liquidity management: Payments are becoming a strategic risk management asset for treasurers. Critical supplier relationships can be resolved by anticipating payments just for the purpose of maintaining the optimal level of loyalty. This decision—while apparently opposite to the dictates of an “orthodox” working capital optimization discipline—certainly helps to mitigate supply chain risk, ensures business continuity and, finally, represents a tool that implements a powerful and effective supplier relationship management strategy.

Bottom line: Don’t look at working capital optimization in isolation. Always remember you are a node of a vast supply network of interconnected and interdependent constituents.