Working capital takes top priority in 2023

By Dan Ginsberg, SGS Maine Pointe

Private equity firms have seen dramatic changes over the past few years in the global economy, interest rates, cost of money and operational costs, resulting in a renewed outlook and shifting priorities for 2023. While growth and positive returns have always been a priority regardless of pandemics and macroeconomic disruptions, how one goes about achieving that growth and those returns has changed. These disruptions, though transitory in nature, have brought about a fundamental change in outlook regarding working capital.

Investors and private equity firms are finding that in the current environment of tighter lending practices, higher operational costs and logistics issues, cash is often unnecessarily locked up in inventory, receivables and payables. In addition, rising interest rates have necessitated more caution in financing. Companies have recognized that because of these cash-limiting disruptions, the next obvious step is to take active strategic measures to optimize working capital and free up cash.

The three pillars of working capital optimization

When operational costs were relatively stable and predictable and low interest rates made financing just as easy as relying on available cash, firms saw less value in a cash culture, and addressed working capital availability in a purely reactionary mode, and often with singular measures such as cost-cutting. Even today in an environment of unexpected inflationary pressure and more expensive borrowing, companies may still panic and limit their response to tactical responses within functional silos.

Opportunities abound, even in economic climates that most consider to be challenging. During those earlier years of plenty, a company may have been tempted to neglect a holistic cash culture in favor of easy finance, but today’s era presents an opportunity to craft something much more long-lasting and effective, which contributes sustainably to the bottom line. This more thoughtful approach builds on the three pillars of working capital optimization: releasing cash, reducing cost and improving service.

This multi-disciplinary approach works across the entire organization, going far beyond simplistic siloed tactics to initiate a transformation that is highly sustainable and allows the company to achieve its maximum cash potential. An example of how this can be achieved is by aligning sales with inventory – through sales and inventory operations planning (SIOP) – two areas that can easily fall out of alignment when the supply chain sees challenges such as those faced during the pandemic. Actual sales not lining up with physical inventory in the pipeline not only results in poor forecasts but also leads to poor service levels, leading to a more long-term dissatisfaction and decrease in revenues. Similarly, cost-cutting, while sometimes necessary, when done without corresponding efforts to maintain or improve service levels, will backfire and result in decreased sales and revenues.

Building a holistic cash strategy

While reducing costs is often necessary, when taken by itself it can be existentially dangerous and may result in a downward spiral. The SIOP process, along with a balance of optimizations across inventory, receivables, and payables, will encourage a continuous cash culture and allow service levels to improve while reducing cost at the same time. The cash culture will also result in lower debt interest; optimized inventory leads to reduced asset requirements and gains in capacity; and the improved cashflow that results will allow more opportunities for self-funded initiatives that do not have to rely on higher-interest financing.

Indeed, there are multiple levers that can be pulled as part of this holistic strategy. In addition to planning more effective and predictable inventory levels and logistics, optimization of receivables will improve cash through integrated tactics such as contract structuring and optimization of customer terms, and minimizing potential disputes. Payables as well is an obvious driver of cash, and a holistic strategy may also incorporate a re-negotiation of payment terms and taking advantage of available price discounts.

Out of the CFO’s office and onto the front lines

It’s time to take working capital optimization out of the CFO’s office and place it where it belongs, firmly on the front line and into the domain of every office and line of business within the company. No longer the privilege of the back office, working capital – to be successfully optimized to the benefit of the company – has to be the concern of everyone.

Most importantly, action must be taken whether a company faces immediate risk or not, lest they find themselves unprepared when the next major disruption catches them falling short and unable to keep up with those competitors that took an opportunity to build a productive cash culture. Companies that have actively encouraged that culture will be better able to withstand those unexpected periods of slow growth and economic challenges, while also maintaining visibility and better control over their cash flow.

Dan Ginsberg is managing director, private equity, at SGS Maine Pointe. Contact: dginsberg@mainepointe.com