 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
CREATING LIQUIDITY - GET A GRIP ON THE CASH FLOW
Hard times or not, a company should always be engaged in activities that sharpen its competitive edge. And one of the most important of these is creating liquidity through making production more cost-effective and releasing tied-up capital right along the production chain. Of the three main drivers of cash flow – operating income and changes in working capital and in fixed assets – better management of working capital on an everyday basis is by far the most usual way of improving cash flow.
The main aims here are to decrease inventory lead times and customer payment time, yet increase payment time to suppliers in order to reduce working capital and the Cash Conversion Cycle. But no matter what activities are carried out, it is crucial that all personnel involved in a cash flow project work in close cooperation to ensure optimal results.
An opportunity with big potential
Tough competition, especially in an economic downturn, is the main motivator for making internal changes to create liquidity as part of concerted efforts to strengthen an organ-ization’s finances. However, before making any changes, it is important to know the difference between income and cash flow. In a nutshell, income is generated through sales of products to customers. Cash flow, on the other hand, is incoming payments from customers, which may be used among other things for outgoing payments to suppliers – all of which is presented on the company profit and loss account. As would be expected, a strong cash flow enables a company to carry out an aggressive business strategy, whereas a weak cash flow puts it in a defensive position, both of which are summarized below.
|
Strong cash flow - Cash available - More flexibility - Lower funding costs - Facilitates good deals - Sustainable profitability - Long-term survival - More attractive business - High confidence – High valuation |
Weak cash flow |
The main drivers of cash flow
There are three main drivers of cash flow:
 Operating income |
| Changes in working capital |
| Changes in fixed assets |
With fixed assets, for example, management may decide to sell a production or storage facility to pay off a bank loan to increase cash flow. Quicker and easier changes to working capital may be required to free up corporate liquidity. Operating income depends primarily on market conditions and is therefore difficult to influence. Management of working capital – short-term assets and liabilities – cover several factors listed on the balance sheet as shown in the table.
|
Assets - Fixed assets - Inventories - Accounts receivable - Cash |
Liabilities and Equitly - Short-term liabilities - Accounts payable |
Another influence on working capital is growth. At first glance, one associates growth with an increase in capital, but the opposite is usually true as expansion tends to bind-up capital. All things being equal, growth also has a tendency to increase the so-called Cash Conversion Cycle, CCC, which is discussed next.
Cash Conversion Cycle
One definition of Cash Conversion Cycle (CCC) is: A metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties. Source: www.investopedia.com
Thus, CCC is very important for businesses that sell products and services as it shows how quickly a company can convert its products into cash through sales. The shorter the cycle, the less time capital is tied up in the business steps, and thus the better for the company's bottom line. Consequently, in an effort to reduce the number of days of a CCC, management must analyze all business activities, which, in addition to the actual production steps, may include business strategy, product development, sales and marketing, after-sales processes, investment method and fixed-asset management, and financial risk management and financing activities.
Over a four-year period, a leading Swedish vehicle producer managed to reduce its CCC from 82 days to just 27 days. As one CCC-day represented 600 million SEK, the total amount of tied-up capital released after deducting investments to achieve this was 18 billion SEK! Although this huge creation of liquidity applied to a very large company, the same principles can be utilized with smaller companies to achieve a significant proportional result.
What we want to achieve
Right along the production chain from production development to the credit time allowed for customer payments, cash flow gradually diminishes. It only becomes positive again when sufficient income is generated. Moreover, although value is continually being added to a product during the manufacturing process, it can only be realized when the batch of products is sold.
We can summarize what we should focus on as follows. We need to:
| Decrease the average inventory lead time |
| Decrease the average customer payment time |
| Increase the average payment time to suppliers, which in turn... |
| ...reduces working capital and the cash conversion cycle! |
But these goals cannot be achieved without close cooperation from all personnel involved in a cash flow project.
As the whole is usually greater than the sum of its parts, each individual project participant should know how he or she can contribute to reaching set goals and use their particular expertise to do so. Typical measures they can initiate are: introducing direct-debit payments, charging a penalty interest, enforcing a freeze time, reducing finished product stock, never paying before the due date, and invoicing on a Friday rather than a Monday.
