Keeping the Lights On (Part 2): Maximizing Cash Flows

Thursday, March 19, 2009 7:37
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With the economic crisis continuing to further weaken the cash flow statement of many firms, large and small, I asked good friend Jay Boyle of Expat CFO to put together his next piece.

Jay is one of the most experienced corporate finance/ accounting people I know in China, and I believe his insights into the current crisis (and its impacts on firms) are important.

In part one of Keeping the Lights On, we discussed costing and how its incorrect usage can cause a company to make poor decisions. In this next installment, we will discuss managing to maximize cash.

When I first began my China career, some thirteen years ago, one of the local operations managers was confused when he learned I had attended a business school to study finance. He inquired what exactly we studied in finance as opposed to accounting. Understanding that he was an operations guy and realizing my Chinese was nowhere near good enough to explain some of the more esoteric financial concepts such as the pricing of different assets classes or financial risk management, I decided it was better I keep it simple and told him that, in finance, we manage cash. He laughed and told me that was easy to manage cash in a company. I had wasted my education. Just delay payment to all of the suppliers while sending an army of collectors into the office of the companies that owed us money. For many managers, that is indeed the answer. It was no wonder that the SOE’s had such a massive triangular debt problem if this was the prevailing view.

Cash is the life blood of any business, and managing it well allows a company to keep the lights on when others are shutting their doors. Managing cash can sometimes be counterintuitive when all management has are the traditional accounting reports and bonuses are based on profitability.

Unfortunately, most people view cash management not any differently then our local manager above. As a result, they have at best poor ROI and, in bad times, needlessly destroy relationships with employees and suppliers.

The Cash or Working Capital Cycle
Before we can understand about managing cash, it is important to really get a feel for the cycle. For the sake of simplicity, we can say that the cycle begins with an order of raw materials, which are converted to finished product and shipped to a customer to create revenue, which becomes a receivable and then is converted to cash. Cash is then paid to the raw material supplier, to labor, used for rent, utilities, taxes, etc., and the cycle repeats.

Regrettably, most management looks at cash only when it is a payable, a receivable or in the bank, a perspective that can often lead to a two-dimensional zero-sum way of thinking that can damage the long-term business and hurt the overall viability of the company. We recommend that our clients refer to the cycle as a “working capital cycle” to expand their view of “cash” as it goes through phase changes much like the steam/ water cycle of a steam ship.

By understanding the cycle, it becomes apparent that the less cash that gets stuck in the system and the faster and more efficiently the cash circulates through the system, the higher the ROI of any investment and the smaller an investment is required of any particular asset.

Effective Cash Maximization Strategies
The below list touches on the most common problems that we find in factories in China.

Look out for VAT “savings”: these are attained at the expense of excess inventory and will bleed working capital.
No one likes paying taxes, and the Chinese are no exception. Probably the most misunderstood tax in China is VAT (Value Added Tax). VAT is a pass-through and is included in every physical input of a product. The most common rate is 17%. When raw material is acquired, VAT is already included in the purchase price. In the accounting books, this amount becomes a contra-liability, or “VAT-input,” and is used to offset VAT owed at month-end. When finished product is sold, the selling price must include 17% for VAT, and it becomes a VAT output. The difference between the two is what is physically paid to the tax department. Most accountants mistakenly believe that if they do not have to pay the tax department, they are saving tax and cash and, as a result, will purchase enough raw materials to offset the amount of VAT owed to the local tax department. It is not uncommon to find many months of raw material on a company’s books due solely to this logic.

Manage incentive structures to align employees’ interests with the working capital needs of the company.
It is often the case that management will be incentivized based solely on accounting profit, leading to a myriad of distortions. One such deviation that is particularly common is that management will unnecessarily build inventory in the fourth quarter of a year in order to shift fixed costs to the balance sheet and reduce the average cost per unit. Building unnecessary inventory is the fastest way to suck the cash out of a company. Changing the incentive system to one that is more balanced to a residual value system such as EVA (Economic Value Added), which charges management a capital charge for the assets of a company, is one way to prevent this by aligning management’s interests with those of investors and conserve cash.

Shorten cycle time to free up cash.
Anything that increases the speed from sales order to cash reduces the need for cash.

Lean initiatives tend to increase throughput and the velocity of product moving through the plant. China-Specific Lean should not be focused too much on JIT (just- in-time) deliveries and level-loading, as these may create vulnerabilities in the production process, but we have had good results with Demand Flow Technology and Theory of Constraints “TOC” queuing and manufacturing techniques.

Manage WIP.
Keeping TOC in mind, it is especially easy to make gains by timing product to move through the factory at the speed of the slowest process or constraint. Doing this will reduce WIP and free up cash.

Review policies and procedures.
It is also critical to thoroughly evaluate written and unwritten production policies. Some of them that were set up to minimize cost or reduce the number of tooling changeovers, such as minimum batch sizes for a production run, can be incredibly cash-consuming. There are numerous initiatives that will allow a firm to get to or close to “build to order.” “Build to order” is an ideal in the lean environment – it means you do not hold finished goods and your processes are so efficient that your customer does not realize you are not producing to stock.

Prioritize orders through customer raking and analysis of tradeoffs.
Through an analysis of receivables, it often becomes apparent that 80 percent of the past due accounts are from 10 to 20 percent of customers. Before you resort to strong arm tactics, you need to evaluate whether it is still worth keeping the client. Often people will say “in this environment any customer is better than no customer.”

It is a good idea, however, to conduct an honest risk assessment.

If that customer goes down, can he take you with him? Rank your customers according to their payment speed and consider processing orders from good clients first. You might consider grouping your customer base into multiple tiers.

Most factories produce different products through the same few processes. Any increase in production takes up additional capacity of the constraint, and there is a trade off between products competing for the constraint, which represents their respective opportunity costs. These opportunity costs should also be considered when deciding which products to produce and ship when an order arrives. Keeping in mind the risk that the customer represents for your operation (as discussed above), a good rule of thumb is to ship the product with the least time in the constraint that has the greatest throughput first.

Identify products that do not use the process constraint
Identifying a product that does not require use of the constraint is an excellent way to easily increase cycle time. Such products can be produced with the slack capacity in the system at non-constraints and are often shipped in parallel.

Match payable and receivables duration
Although most people look at this when they talk about cash management, this is one of the last things we address, as when orders slow, if management has followed the above suggestions and not invested in too much inventory, meeting current payable obligations in a slowing environment is usually not an issue. However, we have also worked with some firms with average payables due in 30 days and average receivables of 180 days. This type of mismatch can suck a company dry. In a situation like this, it is time to meet with suppliers and discuss extending terms. The closer the differential comes to zero, the less working capital required.

In Conclusion:
A company’s health can be greatly strengthened if managers consider the effect of decisions and policies from a cash perspective, questioning entrenched ways of doing things if these result in tying up working capital or bleeding cash from the company. A deeper understanding of the cash cycle can simplify relations with suppliers and buyers as well, allowing the two sides to better understand each other’s needs. There is a lot that can be done to increase cash that will not bankrupt your suppliers and will keep your valuable employees in house, allowing you to survive the industry consolidation that is associated with downturns and prepare for the next expansion. Implementing these strategies today will enable you to KEEP THE LIGHTS ON!

Jay Boyle, EXPAT CFO

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