- Make the connection between P&L and cash flow
- Measure and improve your company's cash conversion cycle
- Become a Cash Soldier for Your Company
Given the recessionary times of the last two years and the current uncertainty, there is still a sense of gloom and doom in many of the economic statistics that are published, whether it's the national debt levels, the unemployment numbers, the GDP or the Dow Jones Industrial Average.
So how do you focus yourself on doing something that creates positive results in this environment? I have tried to script a few things below that can help supply chain managers look at their supply chains and ask the question, "How can I improve my company's financial health position by squeezing more cash out of my supply chain?"
So without further ado, let's take those lemons in our supply chains and start making some greenback lemonade. Here are the things you can do to start making a positive impact:
Understand the connection between the profit and loss (P&L) statement and the cash flow statement. Some supply chain managers do not realize what makes their stock price tick up on Wall Street and how they can contribute to it. For the share price to go up, usually the company needs to have a healthy income level (from the P&L statement) and generate enough cash flow (from the cash flow statement) to fund growth initiatives or dividends. It's generally not enough to have one of them.
So how do we ensure we impact both of them in our daily professional lives? It's not just enough to reduce the cost of a given product; you have to ensure that the cost reduction can be carried over to the cash flow statement to generate cash. More importantly, be cognizant of the fact that cost reductions can sometimes come at the cost of decreased cash flow.
For example, you can negotiate the price of a raw material from $1.50 per pound to $1.40 per pound to get a cost reduction, but at the same time you increase inventory and reduce the payment cycle for the supplier. This might have an adverse impact on the cash flow statement. See the simplified schematic in Illustration 1 for explanation, and you can flow each decision you make through the model shown by the schematic.
The bottom-line is that unless we are able to convert net income to free cash flow, Wall Street won't recognize our efforts. The faster you can convert the product you sell to cash (also called the cash conversion cycle, or CCC), the better financial health your company will be in.
Measure CCC. Once you understand that the above, measure and improve your cash conversion cycle so you can convert your net income into free cash. You will want to measure your cash conversion cycle by each strategic business unit (SBU) as you do for net income. This will present a clearer picture of which business units actually deliver the cash and which are being subsidized. Remember:
Cash Conversion Cycle (CCC) = Sales Outstanding - Payables outstanding + Inventory
Improve your CCC. Once you understand the CCC per strategic business unit, shorten the cash conversion cycle by working on each component and aligning collection and payment cycles. You can use the following levers to improve your CCC.
- Use inventory postponement and package on demand in plants and warehouses. Hold inventory at a work-in-process (WIP) level in the bill of materials (BOM) and differentiate when you get an order. This limits the SKU's you have to hold in inventory on and hence you can hold less inventory. For example, if you are selling identical items to different retailers in different packages, hold the inventory prior to packaging it (a lower level in the bill of material) and pack it on demand.
- Supplier-owned managed inventory initiative in the plants. Urge your suppliers to manage and own the inventory in your plants. Your competitors probably do this. This is quickly becoming not a differentiator but an order qualifier for many suppliers. The idea is not to shift the inventory upstream but to make your suppliers work with you to reduce it. Once they have it, they will work with you on reducing it.
- Cross docking in warehouses. Use a third-party logistics (3PL) provider to synchronize the inbound and outbound movements out of your warehouses. The idea is to never take possession of inventory, but just receive it, turn around and ship it on another waiting truck. Most 3PLs have built this expertise, which was once the forte of a few pioneering companies.
- Apply simple ABC analysis to analyze inventory. Identify As, Bs and Cs by value (volume x cost/unit). Control your As (make every A every day or week, depending on cycle times), and loosen the Cs (which are usually the problem children) to balance investment with service levels. This will reduce inventory as well as improve service levels.
- Define what to make to order and what to carry in stock. A lot of companies by default make everything to stock just because they have always done so. Institute a program that looks periodically at the profitability, velocity and volatility of inventory by SKU. Based on the analysis, make decisions on what to make to stock and what to make to order. As a rule, make to stock the higher velocity, higher margin SKUs. Demand a higher price and lead time for slower-moving and lower-margin products, and make them to order.
Are you bleeding cash?
- Understand the cash inflow and outflow impact — or, in other words, the difference between speed of payment to your supply base and speed of collection from your customers. Supply chains play a key role in optimizing or suboptimizing the accounts payable and receivable cycles for companies.
- Analyze the gap between account receivables (A/R) and account payables (A/P) by company and each SBU if financial reporting permits. You may be surprised to find out that you are paying out faster than you can collect and hence bleeding cash — or borrowing at high interest rates to keep the business going.
- Create the recognition that a day of payables is worth much less than a day of receivables, as there is value added for conversion and then a margin on top of it. This results in the required payables cycle being much longer than the required receivables cycles to net out on cash flow. For example. It's not OK to have 30 days of payables if you have 30 days of receivables. To equal 20 days of receivables in value, your payables probably need to be at 35 days. This actual calculation will depend on your company's conversion and margin structure.
Make the AP cycle greater than the AR cycle
- After you understand where the gap is, identify the business segments/units where you need to create alignment. Create a cross-functional team comprised of Sales, Finance/Accounting and Procurement/Supply Chain. Then, for each business unit, list out:
- Top five customers and collection cycle in days and dollars for customers.
- Top five suppliers and payment cycle in days and dollars for those suppliers.
- Understand the difference between collection cycle and payment cycle for your top fives. Attack the difference and create alignment based on industry practices. In some cases, you might have to renegotiate with your customer and supply base as they are looking for the same cash as you.
Become a Cash Soldier for Your Company
Recognize that most small businesses go out of business due to insufficient cash flow. Use this recognition to squeeze the cash out of your supply chains. Once you start taking a few basic things like those outlined above, you'll see the cash pile up on your balance sheets. This is the cash you can distribute to your shareholders or invest to grow your business. Your Finance colleagues and the CFO will be proud of you as you will be the cash soldiers of your organization.