By Susan Avery
With interest rates still low, companies continue to borrow rather than work on improving operational performance. That’s according to results of the REL 2016 U.S. Working Capital Survey, which also show there’s opportunity for procurement to manage relationships with suppliers in ways that can help generate additional value for companies. REL is a division of The Hackett Group, Inc.
“More of what we’ve seen before,” is how Derrick Steiner, Management Consultant with REL, describes results of the survey to My Purchasing Center. “Again this year we see additional deterioration of the cash conversion cycle,” he says. “Companies are not focusing as much on CCC and improving working capital performance.” A drive: debt.
The cash conversion cycle is the ability of companies to turn spending on overhead, raw materials and labor into cash, and includes collections, payables and inventory. Survey results show the CCC is 35.6 days, down 2.4 days or 7%, figures not seen since before the 2008 financial crisis.
Of the components that make up the CCC, inventory performance worsened significantly, and was the largest factor in working capital deterioration, the study finds. Days inventory outstanding increased by more than 10%, rising to more than 49 days. Days sales outstanding, or collections, worsened by 1.1%, and days payables outstanding, or payables, improved by more than 5%.
The survey, which looks at performance of 1,000 of the largest public companies in the U.S. during 2015, sees corporate debt rising significantly for the seventh consecutive year, a result of low interest rates.
It also shows that the working capital improvement opportunity of companies in the survey is now more than $1 trillion. That’s inventory, receivables and payables. This opportunity represents working capital improvement that could be achieved if all companies reached the working capital performance of the top quartile performers in their industry.
Top performers are now seven times faster at converting working capital into cash than typical companies, the study reports. Top performers collect from customers faster, pay suppliers slower and hold less inventory. Few companies have been able to sustain working capital improvements; just 2% of the companies improved CCC for five years in a row.
Procure to Pay is Cross Functional
This is where procurement comes in. As leaders of cross functional strategic sourcing teams, procurement is responsible for selecting suppliers and managing their performance. With access to market intelligence such as the REL study and sophisticated tools such as dynamic discounting and supply chain financing, procurement can influence DPO by ensuring the figure is in line with market norms.
To be clear, it takes longer today to pay suppliers not because companies are not able to pay them, but because of a shift in market norms. Steiner points out that five or 10 years ago, the norm was net 30 or net 45. Today, in North America the standard is roughly 60 days. In fact, survey results show DPO has shifted from 41 days in 2008 to 50 days in 2015.”
Like their customers, suppliers have more cash on hand and are borrowing at cheaper rates, two reasons they are more willing and able to accept longer payment terms, he explains. “Suppliers are able to take on and are more accepting of extended terms without it having a dramatic effect on their business,” he says. “If procurement teams have payment terms that are less than these, they are probably behind the curve.”
To change that, Steiner recommends procurement establish targets for payment terms by category, keeping in mind geographic region (location of the source of supply) and incorporate the targets into incentive programs. Norms vary by region. In North America, the current target is 60 days. In Asia, it is 90 to 120 days.
For categories, procurement will want to consider such factors as competition and whether the product or service is dual or single sourced. “The general rule of thumb is that as we get closer to the earth, the shorter the payment term,” Steiner says. In other words, payment terms for suppliers of raw materials or commodities may vary compared with terms for providers of categories with lots of competition and little differentiation in product and service offerings such as office products and industrial supplies.
In the discussion with My Purchasing Center, Steiner uses the phrase “supplier payment term optimization.” Procurement is not simply extending payment terms to an arbitrary number. “DPO is a high level indicator and there’s a lot we can learn from it,” he says. “To truly understand the opportunity, we have to peel back the onion and look at it from an operational level. DPO is based on financials, many of which go into the calculation such as payments to the bank and rent payments.”
While procurement cannot influence those payments, it can optimize payment terms with suppliers. “That’s another takeaway: Understanding the metrics at a detailed operational level provides companies with more control and influence,” he says.
And when interest rates rise? If the increase is substantial, Steiner says there will be more focus on the cash conversion cycle and working capital.
“Potentially there’s a risk,” he says. “Suppliers will no longer be open to longer payment terms and willing and able to make concessions. Peering through a reverse lens, suppliers are looking at their own DSO, potentially reviewing contracts and TCO partnerships in more detail and not only looking at the amount of incoming revenue but also understanding the working capital impact and the overall profitability of the customer base.”
The REL 2016 U.S. Working Capital Survey has information for procurement to understand the Cash Conversion Cycle and Days Payables Outstanding. It provides metrics by industry.
Derrick Steiner, Management Consultant with REL recommends procurement look at the figures for supplier, category and geographic region to understand the market norms. “From there, procurement can determine if there’s potential for real results—financial gains and a better way of doing business—by getting in line with market norms and adopting best practices.”
When onboarding new suppliers, Steiner suggests the sourcing team analyze total cost of ownership (TCO) which includes category targets for payment terms. As for incumbent suppliers, procurement should review their contracts periodically. “We often overlook payment terms in the RFP (Request for Proposal) process,” he says. “The market continues to change, and procurement should incorporate changes into overall processes for existing supplier relationships.”
Also see the My Purchasing Center article, What Have We Learned from the Great Recession?
Susan Avery is Editor-in-Chief at My Purchasing Center. She writes articles, blogs and white papers and manages and creates other content for the online procurement and supply management publication. She produces and moderates roundtable discussions, podcasts, webcasts and video interviews. Susan has 30 years experience covering procurement and supply management for Purchasing magazine and Purchasing.com.
George E. Krauter
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