Sales become more important in a growing economy than managing cash well. As a result, many businesses need more cash than required to run their operations. It is easy to get credit in good times but securing more working capital during an economic crisis is not as easy. The recent financial crisis has made businesses introspect and take drastic actions to keep the wheels rolling. The managements of many organizations have learnt that cash is not only life blood all the time, but also king during recession. By adopting a systematic approach, exercising more discipline and providing right incentives, the organizations can free up extra cash, and reduce their working capital requirements.
It is not uncommon to hear that cash is locked up in inventory and account receivables. The inventory accounts for major portion of capital locked which affects the profitability. It is also necessary to maintain some inventory for smooth functioning of the organization. This process decides what and how much of various items are to be kept in the stock. The objective is to reduce investment and ensure smooth functioning of process. But, without looking for cash sinks in their business, management try to make up for the short fall by additional finance from banks or other sources. Many a times, they also end up delaying payments to the suppliers. This article presents the reasons why businesses find themselves in cash crunch situations and what steps they suppose to take to improve such a situation.
Where is your cash ?
The cash is in the form of accounts receivables plus inventory minus accounts payables. The inventory is in the form of raw material, work in process and finished goods. Getting to the root of the problem is an important first step towards improving cash situation. One has to identify cash culprits and act on improving and converting them into opportunity areas for improvement instead of fear about them. The some common cash culprits needs attention on day to day activities especially during recession are lack of discipline, tendency to avoid bold decisions ,wrong performance metrics, System gaps can lead to more cash tied up in inventory and receivables.
1. Gaps in Demand Forecasting: The forecasting is not a perfect science, but its accuracy can be improved over a period of time. It helps and plays important role in better inventory management. The major reasons for the gaps are longer the forecasting period, more is the gap & vice versa. Even if the demand forecasting is pretty accurate, it is often seen that material procurement and production planning are not seamlessly linked resulting in excess procurement of raw materials or more work- work- in process inventory.
2. Artificial Sales: The companies listed on the stock exchanges /borrowed from banks are under pressure to post better results. Under such a scenario, managements have the tendency to pressurize channel partners to lift the finished goods even if there is no real demand. Some times channel partners may themselves lift the goods if they have incentives linked to sales volume but not to collections from customers. By booking such artificial sales, managements are able to show higher sales and profit for their company and they end up deteriorating the cash situation ultimately. This may not be a big problem in good times but when the going gets tough, huge cash is stuck in the stocks in the name of receivables from channel partners.
3. Lose Control on Receivables : The symptoms of this are lag in monitoring, follow-up in receivables and some times sales staff shies away from following up on over due receivables with the fear that customers may run away to competitors. The strict monitoring of these issues will help to keep receivables under your control.
In many organizations, there are delays in sending invoice and related documents to customers. This type of slippage can be used as an excuse for delay in payment by customers. It is also common to find customers holding back payments because the supplier has not resolved their complaints. Then the concerned personnel procrastinate to settle the claims to avoid a charge to the profit and loss account, as a result of either return of goods or compensation to the customers, because it may reflect in their performance measurement. The customer enjoys the benefits of this procrastination, some times, even avoiding payment of those bills which have no relationship with the bills under dispute.
4. In effective Credit Policy : When a company intends to sell its products on credit, it determines credit limits for customers based on likely sales to the prospective customer, expected credit period and the customers risk profile. Once such initial policy is formed and announced, every body starts forgetting over a period of time and rarely reviewed on periodic basis. The review is necessary because initial credit limits may become inappropriate after reviewing the customers buying and payment behavior over a period. Ex: The customer may not buy goods according to the initial plans, similarly some customers may not be making payments as agreed, but may still be receiving goods based on initially set credit limits. It is also seen that initial credit limits are not changed in the hope of a customer placing a bigger order in future. All these adds up to giving more credit to risky customers who may take it for granted.
5. Communication Gap: The management is a cross functional team activity which requires effective co-ordination of various departments to deliver right product to the customer on right time. Given the complexity of todays business operations and geographically dispersed teams, customer requirements may not be communicated well to planning and production departments time to time, leading to wrong procurement of materials or mistakes in final products which customers refuse to accept and some times leading to delay in supply/cancellation of orders for delay in supply/penalty imposed by customers for getting delayed of their ordered goods/loosing faith of valuable customers in future. The single unhappy customer is good enough for loss of few many customers in his near by areas.
6. Over Enthusiasm: Generally custom built products are manufactured based on confirmed order; but some times management initiate material procurement and other planning activities without actually receiving the confirmed order. In such case, if the customer changes her mind, either cancelling the order or changing the specifications, these goods will end up as non-moving inventory. As the business environment is changing drastically over period of time, the customer began using variation in specifications as a delaying tactics to take deliveries. This creates cash flow problems for the company, putting the entire business into trouble. Such custom built products are kept in stock in hope of an order for a similar product in future without any alternative. However this may not happen for the months or some times years and many organizations are willing to take a bold decision to dispose of such items because of non realization of full value, even if, they are aware that the situation would not improve.
7. Focus on Production Instead of Flow of Material: During recession when the market is dull, only manufacture the ordered products instead of producing products without ordered to keep inventory always under control. The inventory which is biggest component of working capital is another form of cash particularly a working capital. The organizations putting major thrust on utilization of all processes to their maximum permissible capacity building higher inventory in the process. This is due to all processes will not be having same capacity and huge amount of material start waiting in front of few processes whose capacity have lesser compared to rest of the processes. Thus they need more cash in managing huge inventory.
8. Lack of Modernization and Up-gradation of Technology: The lack of modernization and up-gradation of technology time to time increases over heads like employment cost, electricity etc which are also part of working capital. These expenses are increasing depending on the inflation and at the time, if production is also increased, then only such expenses also under control, otherwise it is only cost addition rather than value addition.
9. Lack of Control on Consumables: These are not mentioned in the inventory above. This is the 4th important inventory needs attention. The consumables are spares of machineries, stores items which are required frequently, chemicals required for processing/spraying/fuels/water etc. These are not directly involved in manufacturing the product and can not be identifiable in the final products many times also, but they need even special attention especially during recession because these will act as catalyst in production of goods in time with right quality. The practice carrying huge inventory of consumable in the good times of organizations will be carried forward during the bad times, if not monitored & control & hence blocking huge cash.
Once the root cause analysis is done to know the real reasons behind the requirement of extra cash, the next step is to find ways to free up cash from operations. The road to recovering cash is long and arduous and require not of effort on continual basis but a systematic approach, consistent efforts, and right performance metrics can make all the difference.
The author is Senior Manager & HOD Spinning PV, Raymond Limited, Textile Unit, Chhindwara (Madhya Pradesh).