Managing Working Capital to Survive the Downturn

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Managing Working Capital to survive the Downturn

Presenter:

Michael Kealy, Dublin Business School

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Managing Working Capital to Survive the Downturn

Supporting Documentation Index

Contents Page Slide Set 1 – 29 Back Up Paper

Harvard Business Review article “Need Cash? Look inside your Company 30 – 36

Business Strategy Review article “Capital is King” 37 – 40

Harvard Business Review article “Seize Advantage in a Downturn” 41 – 48

Financial Executive article 49 – 52


Managing Working Capital to survive the Downturn

Michael Kealy FCCA

1

Overview

“Late‐paying clients, slashed credit lines

and tightened terms are the realities for today’s small‐ and mid‐sized entities as they scramble to survive in the struggling economic recovery.”

So Cash is King again!So, Cash is King again!

2

OmniPro Education & Training Page 1 of 52


The Response?

• Inaction is the riskiest response

• Anxiety and pressure may target the wrong areas

• A measured and rapid response

3

The Response?

• Companies whose responses are tentative

(e.g. Modest belt tightening etc)

typically overreact later

(e.g. cutting costs rather drastically)

• Ideally, they should plan to be around when the economy recovers.

4



Initial Message

• If cash is king – manage the cashflow

• Profitability measures are now irrelevant

• Management incentives focused on profitability need to be aligned

5

Example

• You are the Purchasing Manager – incentivised by your contribution to profitsyour contribution to profits

• A supplier offers a discount for larger orders

• Accept it – you lock up cashp y p

• Reject it – your incentive reward is reduced

6



The working capital requirement (WCR) =

Working capital and the working capital requirement

inventories + trade receivables − trade payables

The difference between working capital (WC) and working capital requirement (WCR) is:cash less short‐term financial debt (i.e. bank

7

cas ess s o t te a c a debt ( e baoverdraft)

WC = WCR – short‐term debt + cash

The operating cycle relates to working capital (WC)

The operating cycle

The operating cycle relates to working capital (WC), the net of current assets less current liabilities.

The operating cycle is the period of time, which elapses between the point at which cash begins to be

8

expended on the production of a product, and the ultimate collection of cash from the customer.



The Operating Cycle

9

Working capital policy

The policy adopted depends on:

‐ individual company objectives

‐ the company’s trading position

There is inevitably going to be a conflict

between the goals of profitability and liquidity

10




The working capital requirement has normally

been financed by bank overdraft due to :

‐ Its flexibility in accommodating the fluctuating nature of net current assets.

AndAnd

‐ Despite short‐term borrowing being generally more costly than long‐term borrowing.

11

• When demand drops, the policy must change fundamentally

A t f h t t h ll i


• A new set of short term challenges arise

• Businesses must re‐evaluate their approaches to:

– Inventory

Accounts receivable– Accounts receivable

– Accounts payable

12



Balance Sheet ‐ items that impact on short‐term & long‐term cash flow

13

Inventory management – the focus on stock reduction

• In good times, absence of sufficient stock can limit thgrowth

• Inventory management aims to guarantee a constant supply and avoid stockouts

• But....in a recession.... Are you left with excess stock for all production lines?stock for all production lines?

• Different mindset required

14




1. Stop the growth of inventory

– Cancel or postpone orders as soon as sales begin to decline

– Adjust order size to match

15


2. Review order requirements

– Analyse demand and stock levels to rebalance raw materials and WIP throughout the business

– Critically assess any sales assumptions before setting new order levels

16




3. Review buffer stock levels at each stage of the production process

• Where production managers must generate stock to meet demand, the temptation is to retain excess stock levels.

• Differing demand levels pose a challenge

17


Buffer stock levels• Analyse current stock levels relative to new demand outlook –

what & where is appropriate?

• Possibly difficult if stored in various locations; tracked by differing IT systems

• Review raw material levels; WIP on the basis of the finished• Review raw material levels; WIP on the basis of the finished goods required

• This may yield a different view to the conventional

18




bl hEstablish:

1. Robust and revised inventory purchase procedures and reorder systems

2. Accurate and timely systems for the recording, control and physical checks of inventories. p y

19


Also consider systems, if appropriate, such as:

‐ Just in Time

‐Materials requirement planning (MRP) system

‐Manufacturing resource planning (MRPII) systemg p g ( ) y

‐ Optimised production technology (OPT)

20



Just in time (JIT)

A JIT system produces or purchases components and products in response to customer demand.

In a JIT system, products are pulled through the system from customer demand back down through the supply chain to the level of materials and components.

The consumer buys, and the processes manufacture the products to meet this demand – the consumer therefore determines the schedule.

21

Materials requirement planning (MRP)

A Materials Requirement Planning MRP (or MRPI) is

‐ a system that converts a production schedule into a listing of the materials and components, required to meet that schedule

‐ a system that ensures that adequate inventories levels are maintained and items are available only when needed.

22



Manufacturing resource planning (MRPII) is an expansion of material

Manufacturing resource planning (MRPII)

requirements planning (MRPI) to give a broader approach than MRPI

to the planning and scheduling of resources, embracing areas such

as:

‐ finance

‐ logistics

‐ engineering

‐marketing

23

OPT i hil h bi d ith t i d

Optimised production technology (OPT)

OPT is a philosophy, combined with a computerised system of shopfloor scheduling and capacity planning

OPT differs from a traditional approach of balancing capacity as near to 100% as possible and then maintaining flow

24



OPT aims to balance flow rather than capacity, and like JIT, it

Optimised production technology (OPT) (Continued)

OPT aims to balance flow rather than capacity, and like JIT, it

aims at improvement of the production process and focuses

on factors such as:

‐manufacture to order

‐ quality

‐ lead times

‐ batch sizes

‐ set‐up times

25

Other Inventory Related Steps

• Sales campaigns / promotions

– focused on products with excess inventory levels

• Product bundling offers

• Add on packages

• Are deep discounts justified for products prone to obsolescence?

26



Other Inventory Related Steps

• Negotiate more favourable supplier terms

• Challenge:

– Safety stock requirements

– Service levels

Q lit ti– Quality assumptions

• Re‐evaluate make to order vs. make to stock attitudes

27

Accounts Receivable

• In a downturn, receivables management changes d ti lldrastically

• Risk of default increases dramatically

• Cash collection is critical

28



Accounts Receivable

• A different approach to customers

• Economy affects different customers differently

• Are financially strong customers willing to pay earlier for better prices?

• Are cash strapped customers willing to pay higher prices for better repayment terms?prices for better repayment terms?

29

Accounts Receivable

1. Re‐evaluate existing credit policies

‐ stricter guidelines for credit approval

‐ lower limits on amounts outstanding for any one customer

‐ reduce in size transactions needing management approval

30



Accounts Receivable

2. Credit worthiness

‐ track customers position more vigorously

3. Collection Process

‐ avoiding bad debts is not possible

‐ earlier invoicing

‐ earlier payment reminders

‐ strict adherence to credit terms

31

Accounts Payable

• When economy is strong, terms are negotiated d id di land paid accordingly

• In a downturn, can be a low‐cost source of funding

• “Leaning on the trade” can provide short term funding when cash is tight

32



Accounts Payable

• Conserve cash – never pay suppliers early

• (Re)Negotiate for extended terms or for major discounts for prompt payment if possible

33

Accounts Payable

• Consider your supplier’s viability and the risk that l b di t dyour supply may be disrupted

• If a supplier is in financial difficulty, consider:– Purchasing larger volumes

– Arranging shorter payment terms

• Result may be:y• Continued supplies

• More advantageous relationships

34



Accounts Payable

• For non strategic suppliers with liquidity blproblems:

Consider negotiating vigorously for larger discounts

35

Accounts Payable

• What can we do where suppliers act defensively:

‐ to protect margins

‐ eliminate favourable payment terms

‐ increase prices

‐ reduce deliveries

‐ restrict credit

36



Accounts Payable

• Our response may be:

– Consolidate orders with a smaller number of preferred suppliers

– Order larger amounts

– Cancel orders

– Threaten to leave a supplier if better terms cannot be ppnegotiated

37

Accounts Payable ‐ example

• An approach by a major retailer to strategic li ith li idit blsuppliers with liquidity problems was:

– Reduce average payments terms from 60 days to 15 days

– Receive price reductions from 1 – 3 % in return

• Result was:• Reduction of retailer’s overall costs

• A strengthened relationship with strategic suppliers

38



Avoid drastic actions

• Drastic action may release short term cash

• But.....evaluate trade offse.g. A financially strong company should seriously consider the

benefits gained from reducing terms for financially weakened suppliers

• May give a quick win

• But may leave a sour taste and supply disruptions when demand returns

39

Avoid drastic actions

• May give a quick win

• But may leave a sour taste and supply disruptions when demand returns

Companies should manage their cash for the short term and their business for the long term

40



No alternative to drastic action?

• If not, companies must:

– Aggressively manage their cash

– Use every possible option to strengthen their position

– Ignore the damaging consequences

– Return stock

– Delay paymentsDelay payments

– At the end of the credit period, pay by company credit card

41

No alternative to drastic action?

• If not, companies must:R ti t t ith k li– Renegotiate terms with weak suppliers

– Offer purchase incentives

– Offer volume discounts

– Sell unwanted assets

– Postpone new projects

d ff b– Reduce staff numbers

– Shorter working week

– Pay cut for management and staff

42



Alternative positions

• If your company has steady demand but i ffi i t f d f h t t iinsufficient funds, focus on short term wins:

– Front load sales through volume discounts

– Offer price breaks for early payments

– Control stocks and payables to avoid being squeezed by suppliers

– Invoice Discounting

– Asset finance e.g. leasing

43

Alternative positions

• If your company is highly liquid with declining demand, focus on gaining market share:demand, focus on gaining market share:

– Offer extended payment terms to high value customers

– Negotiate aggressively with suppliers for greater discounts in exchange for more favourable payment terms

• Act strategically

‐ accept excess inventory on less favourable payment terms from p y p ystrategic suppliers and other important customers.

44



Working Capital Benchmarking

• Situate your company on the planning matrix on th t lidthe next slide

• Contrast your position with your competitors

• This may give you a sense of where to focus your cash release efforts

45

Plan on the basis of Demand and Liquidity



Evaluate Potential actions

• Consider each potential action on the basis of:

– Its Escalation level i.e. Its severity and impact on the business

– How quickly benefits will be derivedHow quickly benefits will be derived

47

Evaluate actions on Basis of Escalation and Time Frame



An Integrated Cash‐Management System

• The Goal:

– Not just generate cash in the short term

– To achieve greater insight into available cash through planning; forecasting

– To link these to the causes of cash flow

• Integrated cash management has three elements:g g

– Cash governance and organisation

– Cash visibility

– Active cash management

49

Integrated Cash Management‘s three key elements



Cash Governance and Organisation

• Deeply embed cash management so that it b k t t ibecomes a key management metric

• Throughout the organisation – not just in accounting function

• Train staff

• Link rewards to cash flow targets• Link rewards to cash flow targets

• Aim is to make it a fundamental part of everyday operations rather than an crisis issue

51

Cash Visibility

• Plan and monitor

• Analyse cash implications of all strategic plans

• Test projections to know how cash position changes

• Identify gaps between base performance level and target cash leveltarget cash level

• Develope systems; processes to monitor the cash position and track its improvement measures

52



Active Cash Management

• Actively manage the cash position by using the i t lli kl thl h tappropriate rolling weekly or monthly cash reports

• Other actions include:

– Pooling cash across operational units

– Optimising fixed assets

– Reducing costsReducing costs

– Increasing sales

53

Active Cash Management

• Other actions include:

– Reduce Debt

– Sell off non‐core assets or business units (do not wait for better times – do it now!)

54



And Finally.....look to the future

• In 2001, Apple was in poor shape heading into the 2001 –2003 recession2003 recession

• Revenue fell 33% in 2001 over 2000

• But Apple increased its R&D spend by 13% in 2001 to approx 8% of sales from 5% of sales in 2000.

• It maintained that level in 2002 & 2003

• The Result:The Result:‐ Apple produced the iTunes music store and software in 2003 and the iPod Mini and the iPod photo in 2004

‐ A period of rapid growth for the company ensued

55

And Finally.....look to the future

Companies should manage their cash for the short term and their business for the

long term

56



Need Cash? Look Inside Your Company by Kevin Kaiser and S. David Young Harvard Business Review

The boom years made businesses careless with working capital. So much cash was sloshing around the system that managers saw little point in worrying about how to wring more of it out, especially if doing so might dent reported profits and sales growth. But today capital and credit have dried up, customers are tightening belts, and suppliers aren’t tolerating late payments. Cash is king again.

It’s time, therefore, to take a cold, hard look at the way you’re managing your working capital. It’s very likely that you have a lot of capital tied up in receivables and inventory that you could turn into cash by challenging your working-capital practices and policies. In the following pages, we’ll explore six common mistakes that companies make in managing working capital. The simple act of correcting them could free up enough cash to make the difference between failure and survival in the current recession.

Mistake 1: Managing to the Income Statement

The first favour you can do your company in a downturn is throw any profitability performance measures you may be using out the window.

Suppose you are a purchasing manager and your performance is judged largely by your contribution to reported profits. Chances are, a supplier will at some point propose that you buy more supplies than you need in return for a discount. If you accept the offer, you will have to lock up cash in holding the extra inventory. But since inventory costs do not appear on the income statement, you will have no incentive to turn your supplier’s offer down, even if you take the trouble to calculate those costs and find that they are greater than the gains from the lower prices. In fact, if you do turn the discount down, your compensation, which is linked to the income statement, is likely to suffer, even though your decision may be good for the company.

Whether they’re in manufacturing or in services, companies that hold managers accountable for balance sheets and not just profits are less likely to fall into that trap. Managers will have every incentive to explicitly measure and compare all costs and gains in order to determine the best course of action.

The same argument applies to all the components of working capital. Take receivables. Let’s assume that you are contemplating reducing your terms of payment from 30 days to 20 days. You assess the likely impact on customers and estimate that you will have to reduce prices by 1% to compensate for the tighter terms and you will sell 2% fewer units, which will lead to a drop in after-tax operating profit of $1 million this year. On the other hand, if the company generates $2 million in sales per day, shortening receivables by 10 days would free up $20 million in capital. Assuming an opportunity cost of capital of 10% (that is, you could make alternative investments that would generate a 10% return), you should be willing to sacrifice up to $2 million in profit per year to get your hands on this capital. The decision, then, is quite clear: If you estimate that profits will fall in future years in excess of that $2 million, you probably should not reduce your payment terms. But if you estimate that the profit loss will be less than the return on your $20 million, you definitely should.

A metals refining firm that had extraordinarily high levels of receivables in its Japanese business illustrates precisely this calculus. Following the company’s acquisition by a private equity firm,



managers started requiring salespeople to call customers a week before their payments were due to remind them. The salespeople were predictably horrified. “This is going to drive customers to the competition for sure,” they protested.

The incoming senior vice president countered their objections by asking a simple question: “How would your customers feel if we deliberately delayed shipping their products until after the agreed-upon date? Would they hesitate to call us?” “Of course not!” the salespeople responded. “So then why should customers that consistently pay late be surprised when we call to remind them that their payments are coming due?” With this perspective, the sales force enthusiastically started calling customers to encourage on-time payment. As a result, receivables fell from 185 days to 45 days, putting the equivalent of $115 million in recovered capital back into the bank account and reducing capital costs by $8 million a year. Sales did decline, but the resulting loss in margin was only about $3 million. The reduction in receivables clearly outweighed the loss in sales from demanding faster payment. This is the sort of trade-off that we urge all companies to consider.

Mistake 2: Rewarding the Sales Force for Growth Alone

Although most general managers are rewarded to some extent for controlling costs—even if only for those savings that appear on the income statement—cost discipline is very seldom applied to people on the front lines. Salespeople’s compensation plans in particular tend to be linked to unit or dollar sales generated. There are several downsides to this.

Most obviously it encourages sales folks to book sales at any cost. It also makes concessions in the terms of trade more likely, as salespeople look for ways to get customers to buy. They grant customers long payment delays and are unwilling to chase down late payments. Fearful of sales-destroying stock-outs, they insist on larger than necessary finished-goods inventories. High receivables and high inventories mean that a lot of cash is locked up in working capital.

This is a pity, because a properly motivated sales force can do wonders to wring more cash out of your sales. And you don’t necessarily have to go to the length of completely changing the comp system. Sometimes all you need to do is make people aware that there’s more to sales than booking the deal.

That’s precisely what happened when the metals refining company instituted the more aggressive policy on receivables. The additional contact that the policy necessitated between sales staff and customers ended up shining a spotlight on each customer’s financial condition. Customers with potentially bad receivables could be identified earlier and shifted to pay-on-delivery terms, even before they exhibited the full symptoms of financial distress. When one of those customers did begin to default, the impact was minimal, because the company had already instituted pay-on-delivery terms. The overall result was a decline in the percentage of overdue or bad receivables from 12% of the total to less than 0.5%, yielding annual cash gains of nearly $3 million.

Or consider the case of a global electrical component manufacturer that catered to utilities, power generation, and distribution companies. A large portion of its sales came from emerging markets, especially China. However, sales in China generated receivables that had painfully long payment terms and were often of dubious quality. When challenged to improve on this performance, the sales force argued that the Chinese way of doing business imposed “flexible” payment terms and that a stricter policy would result in a big loss of market share.

When sales results were disappointing despite the flexible terms, a task force was assembled to analyze the underperformance in the Chinese market. It turned out that the main issue was incorrect



price positioning; extended payment terms were often rebates in disguise. In addition, salespeople often had the wrong documentation, which prevented the company from collecting invoices on time. Once the processes were fixed, payment terms converged on the industry standard, and the product/price grid was corrected. The result of this modest effort was a sharp reduction in receivables, which freed up more than $10 million in cash for a company with sales of $400 million. Meanwhile, receivables quality improved without harming market share.

Mistake 3: Overemphasizing Quality in Production

On the production side, the chief source of working-capital mismanagement lies in the structure of incentives—essentially the same story we saw on the sales side. Production people are often evaluated on quality metrics, such as the number of defects in finished goods. This is understandable given concerns about warranty costs and the reputational harm that quality problems can cause.

But although quality control reduces those costs, it tends to slow down the production cycle, locking up capital in work-in-process (WIP) inventory. At one European producer of drive systems for power generation, which has annual revenues of about €1 billion, production managers were given bonuses on the basis of their ability to reach or exceed agreed-upon reductions in product defects each year. Managers were also rewarded for incorporating an ever-increasing array of new features into products. The firm had a strong reputation for quality, which allowed it to secure some valuable long-term sales contracts, but over the years, its increasingly complex production processes led to a manufacturing cycle nearly three times as long as those of its competitors.

When we asked whether customers appreciated this extra care, senior managers were quick to point out that their products were recognized as being of the highest quality. But, we asked, were they able to pass along the extra cost to customers? They admitted that customers often lacked the engineering sophistication to appreciate the incremental quality built into the products and were therefore unwilling to pay a higher price for them. Gradually the executives came around to the idea that they should stop trying to convince customers that the added quality was worth the difference in price and instead focus on reducing WIP inventory to keep costs down. After a determined effort to speed up production and scale back on non-value-added quality, the firm was able to cut WIP inventory by 20 days. Although cycle times were still longer than industry averages, the inventory reduction freed up €20 million in cash.

For an Italian food manufacturer we studied, a significant share of its product portfolio consisted of items that were aged between 12 and 24 months. These products commanded a price premium and represented almost a quarter of total sales, but they also generated below-average returns compared with the rest of the portfolio. The disappointing results were due to the high WIP inventory levels associated with maintaining product quality. Management insisted that the contribution to profit was highly significant, that these products were must-haves in the portfolio, and that they enhanced the prestige of the brand.

Only after the economic environment worsened did management concede that the quality advantage conferred by their aging process was no longer defensible. Through a comprehensive redesign of the manufacturing process, including outsourcing arrangements, the company was able to free up tens of millions of euros in capital previously tied up in inventory. Although quality dipped, the change was imperceptible to customers, and thus the impact on margins was negligible. Because the company was able to maintain margins with much less capital, the return on invested capital dramatically improved. An important takeaway here is that although the customer may be willing to pay for high quality, companies should take careful notice of what that quality really costs. By



sacrificing a small amount of quality to make a notable improvement in efficiency, a firm can maintain its reputation while freeing up large amounts of cash.

Mistake 4: Tying Receivables to Payables

Many companies relate the terms they are given by their suppliers to the terms they offer their own customers. If their suppliers tighten terms, they try to cover the resulting cash call by tightening their own credit policies.

But this implicitly assumes that a company’s relationship with customers mirrors its relationship with suppliers. Just look at the retail business to see how false that assumption is: A hamburger chain like McDonald’s takes between 30 and 45 days to pay its suppliers. Does this mean that it gives the customers in its restaurants 45 days to pay for their meal?

The truth is that receivables and payables represent entirely separate sets of relationships, which need to be managed according to their own conditions and imperatives. Relative bargaining power, the nature of competition, industry structure, and switching costs will ultimately determine the terms that a company can dictate to its customers or must accept from its suppliers. In nearly all cases these factors will differ across the two sets of relationships. A firm may, for example, have less bargaining power with suppliers than with customers, and its customers’ switching costs may be quite different from those the firm contemplates when considering a change in suppliers.

The auto industry provides an example of why this distinction is so important. Excess capacity and low switching costs for car buyers have prompted many automakers to offer customers five-year payment terms with no money down and no interest. But because of far higher switching costs on the other end of the value chain, carmakers have been unable to extract similar terms from their suppliers. Even if they could, it would be a bad idea—they would most likely end up bankrupting their suppliers.

In recessionary times the practice of linking receivables to payables is even more prevalent as companies look for ways to make up shortfalls. Imagine a hypothetical company in the machine tools business. Although it operates in a competitive business-to-business industry, the company has built up a loyal set of customers to which it offers a unique value proposition. Part of that proposition involves 30-day terms of trade. Suppose the company sources a large share of its supplies from one major steel manufacturer, which suddenly and unilaterally reduces its terms of trade by 10 days. This move leaves our company scrambling for new cash to plug the resulting $20 million hole in its capital.

To find the cash, the company succumbs to the temptation to reduce its customers’ grace period by 10 days as well. The problem is that, unlike its supplier, the machine tools company does not enjoy market power over its customers. Competitors’ offerings now look more attractive since our company has shortened its payment times. As its salespeople predicted, the company experiences an almost immediate 20% drop in business, from $100 million to $80 million, leading to a decline in after-tax profit of $6 million for the year.

Although the change in supplier terms was unfortunate and costly, it should in no way have been a reason for revisiting the customer relationship. If the company could have shortened the collection period without destroying value, it should have already done so. Tightening terms with customers allowed the firm to capture $3.8 million from receivables reductions—but that drop of $6 million in after-tax profit caused it to lose cash in the first year. If this profit decline were to persist, and



assuming a 10% cost of capital, $60 million in value would be destroyed. Had the company not tied receivables terms to payables terms, it wouldn’t have destroyed this value.

We recently worked with a French small-appliance manufacturer on working-capital management. The company was applying exactly the same terms of trade to all its counterparties; we immediately suggested that senior managers analyze all relationships on both ends of the value chain. In doing so, they discovered big differences in the balance of power not only between suppliers and customers but also between different types of suppliers and different types of customers. As the largest player in its industry segment globally, the company enjoys a strong bargaining position relative to its suppliers. However, a huge percentage of its sales are distributed through giant retailers, such as Wal-Mart, Carrefour, and Metro.

Acting on this analysis, the company introduced new terms of trade for each supplier and customer segment. For example, after it acquired a financially distressed competitor and negotiated with the new customer segments, management reduced customer payment terms by more than 20 days and increased the company’s own payment terms to suppliers by about eight days. That put €35 million in capital back in the bank, a significant sum for a business with annual revenues of just under €450 million.

Mistake 5: Applying Current and Quick Ratios

When bankers assess their customers’ creditworthiness, they often think in terms of current or quick ratios—indicators of how much cash or cash-equivalent a company can count on to meet its obligations. The current ratio is simply a company’s short-term assets (cash, inventory, debtors) divided by its short-term liabilities (creditors, taxes, and deferred dividends). The quick ratio subtracts inventory from short-term assets and divides the result by short-term liabilities.

Although current and quick ratios are popular with many bankers and some managers, they can be misleading. Worse, their use encourages companies to manage according to a “death scenario.” Bankers want to ensure that companies have enough liquid assets to repay their loans in the event of distress. The irony is that the more closely a company follows its bankers’ guidelines, the greater the likelihood that it will face a liquidity crisis and possible bankruptcy. That’s because a higher (which to bankers means “better”) current ratio value is achieved by having higher levels of receivables and inventories and a lower level of payables—all quite at odds with sound working-capital practices.

Alternatively, suppose that the quick ratio is your main yardstick for determining working-capital levels, and you manage operations carefully to maximize that measure. To the extent that it discourages high inventory levels, this approach has some merit. Unfortunately, it also encourages you to build up your levels of receivables indiscriminately—which, as we have already seen, is usually not a good idea. As long as credit is easy, this approach, though value destructive, will not cause a liquidity headache. But when a credit crunch takes hold, the company will quickly run out of cash. Experts in structured and leveraged finance therefore tend to ignore current and quick ratios, focusing instead on cash flow generation as a sound measure of short-term liquidity.

Managing to the bankers’ ratios has gotten many company executives into trouble. Perhaps the best example comes from a French consumer goods company whose CEO announced in 2001 with considerable pride, “Our working capital has increased from €1 million to over €4 million with our current ratio rising from 110% to 200% and the quick ratio rising from 35% to 100%.” The company declared insolvency six months later.



Mistake 6: Benchmarking Competitors

Common management practice is to benchmark a set of metrics—a scoreboard of sorts—in comparing a company’s performance with industry competitors. The trouble with this approach is that companies become complacent when the scoreboard indicates that their metrics are above industry norms.

The best companies strive to improve radically on industry norms, often looking outside their industry for benchmarks. Consider Dell Computer in the early 1990s. Michael Dell knew that his company was already best in its class in terms of key working-capital metrics (days of inventories, receivables, and so on). A comprehensive consultants’ report showed him that his company had little to learn from other computer companies, but his satisfaction was short-lived. When he started comparing Dell Computer with retailers, he very quickly realized that his company’s performance wasn’t so special after all, and he resolved to completely overhaul the company’s working-capital practices.

Or consider the example of the metals refining company cited earlier. The incoming senior vice president travelled to Japan to examine why the business there was accepting those receivables terms of 185 days and maintaining three to four months’ worth of finished-goods inventories. He learned in his initial discussions with the sales force and key customers that these figures were norms for the industry and was advised to leave them alone.

But as he pressed harder with customers, he came to realize that his company’s product quality and reputation were such that he did not need to stick to these norms. He managed to convince customers that the company could ensure delivery with only one month’s worth of inventory, and to prove his point he offered to accept stiff penalties for late delivery. He also offered discounts for early payment, leading to the drop in receivables from 185 days to 45 days. Other avenues for value creation opened up in the course of his Japanese tour: Customers turned out to be less price sensitive than the company had long assumed, which left room for price hikes of 3% to 52% across the product line, more than making up for the early-payment discounts.

None of these improvements would have been possible if the company had relied entirely on the standard industry benchmarks to guide its working-capital practices. To be sure, such studies are a logical and necessary exercise for companies seeking to improve, but real breakthroughs come from the willingness to shed the straitjacket imposed by benchmarking. Difficult times require creativity, and creativity doesn’t come from comparing yourself with competitors. It comes from an intimate knowledge of your customers, suppliers, and production processes, and the opportunities such knowledge offers to do more with less.

Creating a Culture of Value

The stories we’ve related illustrate the same larger point. Motivating managers by numbers alone never works, because when managers focus on maximizing a particular performance indicator, they almost always end up destroying value. A far better approach is to foster a culture in which managers from all functions engage in a dialogue with one another, with suppliers, and with customers about value creation. Incentives and performance metrics certainly play a role, but a company’s leaders must always be alert to the danger that their managers will end up optimizing their performance metrics at the expense of the company’s balance sheet. CEOs should think back to the early days of their careers. They must have frequently encountered managers who said, “I



know that doing this is dumb, but my bonus will suffer if I don’t do it, and it’s not my responsibility to fix the system.”

But getting people at all levels to help fix the system is precisely what you must do if you’re to have a consistently healthy business. Toyota is perhaps the best place to look for a model of the culture you need to create. In their influential 1999 HBR article, “Decoding the DNA of the Toyota Production System,” Harvard academics Kent Bowen and Steven Spear argue that just-in-time production is not about applying a particular set of tools and practices; it is about creating an environment in which all workers are rewarded for and guided in constantly experimenting with their work processes, asking questions, and testing hypotheses. In such an environment, performance indicators certainly play a role, but they are not blindly and unquestioningly followed. The result is a participative culture in which all employees feel responsible for creating value. It’s precisely the kind of attitude that will ensure that the capital in your company is working as efficiently as it can.



Working capital is the cash a companyneeds to have on hand in the short term tokeep the business running – pay its

employees, suppliers, taxes and so on. The nakedtruth about working capital is that it doesn’t matterhow clever your products or how keen yourcustomers: if you haven’t got cash on hand to keepyour business moving, you’ll be out of business, asnumerous hedge funds and others learned the hardway in the financial crisis that began in 2007.

In a time of recession especially, what managersshould be thinking about, in a strategic sense, iscash flow rather than profit. From a business modelpoint of view, profits are irrelevant. Why? Failure toearn a profit won’t put you out of business, as longas you still have cash. But if you run out of cash,even if you are profitable, you’ll be gone in aheartbeat. Cash, as they say in entrepreneurialcircles, is king. Consider the case of Costco, a US-based company with over 550 membership-onlywarehouses that, in 2008, generated over $71billion in revenue. Costco has become the pre-eminent warehouse club retail chain, largelybecause management designed its working capitalmodel to gain competitive advantage.

Roots of cashWhile Costco’s working capital model wasrevolutionary, it was by no means original. Its modelwas based largely on Price Club, its progenitor.

Price Club was created in 1976 by Sol Price in SanDiego, California. His original and prescient leap offaith was that, by changing the working capitalmodel in retailing to permit vastly lower prices, hecould charge customers for the privilege of shoppingat his stores. The key to Price’s early success washis counter-intuitive credo, his refusal to try tosqueeze an extra dollar out of his customers. AsGoldman Sachs retail analyst Stephen Mandel, Jr.,would later attest, Price Club was the industry’sbest practitioner, turning its inventory about 20times annually, while possessing negative workingcapital of about $3 million per warehouse.“Negative working capital” is a cash flow model inwhich stores can sell and deliver a product beforethey ever have to pay for it.

Move inventory quickly and charge a membershipfee? It held the makings of a working capital modelthat was little short of spectacular. Costco co-founder and CEO James Sinegal recalls (and livesby) Sol Price’s principles. “Many retailers look at an item and say, ‘I’m selling this for 10 bucks. How can I sell it for 11?’ We look at it and say, ‘How can we get it to nine bucks?’ And then, ‘Howcan we get it to eight?’ It’s contrary to the thinkingof a retailer, which is to see how much more profityou can get out of it. But once you start doing that,it’s like heroin.” There was another element, too.“You had to be a member of the club. People paidus to shop there.”

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CAPITAL IS KING!The business world is, hopefully, emerging from a mega-downturn. So, shouldthe savvy businessman be focused on the top line (revenues) or the bottomline (profits)? Says John Mullins: neither! Working capital is what companieslike Costco need to survive, and it may also be precisely what your businessneeds to prosper.



In 1981, Jeffrey Brotman recruited JamesSinegal away from Price Club, where Sinegal hadworked since his teens, rising rapidly through PriceClub’s ranks. In 1983, they launched CostcoWarehouse in Seattle. At the heart of the Costcostrategy was the Price Club working capital model.First, there was the membership fee. For familiesthe fee was $50 per year; corporate customers paidup to $100, collected before the customer everstarted shopping. Second, Costco collected cashfrom its customers almost immediately – no creditcards, thank you, but cash, a check, or your debitcard (which gave Costco instant cash) – maintainingjust three days of accounts receivable. And, asCostco later proclaimed, “Because of our high sales

volume and rapid inventory turnover, we generallyhave the opportunity to sell and be paid forinventory before we are required to pay many of ourmerchandise vendors, even though we takeadvantage of early payment discounts. As salesincrease and inventory turnover becomes morerapid, a greater percentage of inventory is financedthrough payment terms provided by vendors ratherthan by our working capital.”

With its customers providing the cash needed togrow, Costco soared. By 1996, Costco wasgenerating $19 billion in sales and $423 million inpre-tax net income. Let’s look at the working capitalnumbers that were making this possible:

� Current assets (other than cash): 35 days

� Inventory: 32 days

� Accounts receivable: 3 days

� Current liabilities: 41 days

� Accounts payable: 27 days

� Membership dues: 14 days (half of membershipdues was taken in income in the current year, andhalf stayed on the balance sheet to be taken inyear two)

� Net of these elements: – 7 days

Costco’s working capital model let it get away withrazor-thin overall profit margins, since earning anattractive return on investment when yourinvestment is near zero (thanks to negative workingcapital) can be accomplished with very modestprofits. So Sinegal passed on to his customers thebenefit in lower prices. He was underselling hiscompetition while growing the business on itscustomers’ cash. How did Sinegal and his team takethe fat out of margins? First, they were tough

negotiators. Second, they bought items to sell invery high volumes and used that as a leverage toask more of their suppliers than others could. Forexample, when Costco was selling $100,000 worthof salmon per week, they were able to use thatvolume to convince the salmon supplier to removethe skin and debone the fish and ultimately chargeeven less for the fillets.

Costco also insisted that no item could be markedup to a gross margin over 14 per cent. Contrast thatwith supermarkets and department stores, whichcarried 20 to 50 per cent gross margins; discountstores like Kmart and Target also had greateraverage gross margins across their product mix,ranging from 25 to 30 per cent. To turn inventory

quickly, Costco carried just 4,000 items. A typicalsupermarket, Sinegal explained, carried 40,000items, while a Wal-Mart super centre would stocksome 150,000. With only 4,000 items at rock-bottom prices, Costco could pick items that it knewwould move off the floor quickly. Items weretransported straight from the vendor to the salesfloor. No costly warehouses full of expensiveinventory tying up precious cash.

There was one key element, though, on whichSinegal parted ways with Price Club. Price Clubtargeted small businesses and working-classfamilies – something that rival Sam’s Clubmimicked. For Costco, Sinegal targeted smallbusinesses and more upscale families, more than athird of which had household incomes greater than$75,000. As retail consultant and author MichaelSilverstein explains, these consumers are happy topay for upscale items that “make their heartspound” and for which they don’t have to pay fullprice. Then they trade down to cheaper privatelabels for things like paper towels, detergent,vitamins and other household staples. “It’s theultimate concept in trading up and trading down,”says Silverstein.

Three-quarters of Costco’s product assortmentwere basics, from 24-count packages of toilettissue, Costco’s top-selling item, to a lifetime supplyof panty shields. The excitement that broughtcustomers back, however – returning once every 17days on average, lest they miss out on a bargain –came from the other quarter. From $800 espressomachines this week to $29 Italian-made Hathawayshirts next week to $1,999 digital pianos the weekafter, Costco’s stores offered something for everyoneand at bargain prices other merchants simply could

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If you haven’t got cash on hand to keep your businessmoving, you’ll be out of business.



not touch. “We always look to see how much of agulf we can create between ourselves and thecompetition,” says Sinegal.

Positive negativesBy 2006 Costco had 48 million members and itsstores were generating an average of $120 millionin annual sales. Best of all, its working capitalmodel had become even more attractive:

� Current assets: 35 days (no change from 1996)

� Inventory: 32 days (half Target’s, its discountstore competitor)

� Accounts receivable: 3 days

� Current liabilities: 46 days

� Accounts payable: 32 days (improved by 5 daysagainst 10 years earlier)

� Membership dues: 14 days

� Net of these elements = – 11 days

Costco’s 11 days of free customer cash amounted tonearly $3.6 million per store, more than enough tobuild a new store for each one currently open.

What was the impact of Costco and its warehouseclub brethren on the rest of retailing? Long-sufferingKmart went into bankruptcy in 2002, and its 2004merger with Sears held out little hope that eitherchain could compete with the likes of Costco, orwith Target and Wal-Mart, which have continued tothrive. But discount and department store chains

weren’t the only retailers to feel Costco’s bite.Costco’s $2 million per week in fresh salmon salestook a chunk out of supermarkets’ fresh seafoodsales and brought shoppers to Costco for moregroceries than seafood or toilet tissue. Its fast-changing assortment of durable goods helped slamthe brakes on retailers in other categories, too.

In 2006, the average Costco store generatedalmost twice the revenue of Wal-Mart’s Sam’s Clubstores. Compared with Sam’s Club, Costco had 82 fewer outlets, but generated about $20 billionmore in sales, some $59 billion. Its pre-tax profit of $1.7 billion, of which nearly $1.2 billion wasmembership fees, was a slim three per cent ofsales. With customers paying for the privilege ofshopping, thereby providing the cash needed forrunning and growing the business, who needed high

profit margins? It’s exactly how Sinegal wanted it. “I hate to sound so simple,” he says, “but all we’retrying to do is sell the best quality merchandise fora better value than anyone else.” Costco was rankednumber 29 in the Fortune 500 in 2008 and wasthe world’s fifth-largest retailer.

Generally, negative working capital is an attractiveroute forward if you can find a way to achieve it inyour business. For many savvy businesspeople, infact, negative working capital is their Holy Grail.The negative working capital model offerssignificant benefits that are well worth striving for,and it is not an exotic financial scheme. Thus, thequest for more efficient working capital models isfar more widespread than the one example ofCostco. In the 1990s, the manufacturing industrygot into the game. Companies such as AmericanStandard, Whirlpool, General Electric and otherssought to move from the Fortune 500 average of 20cents in working capital for each dollar of sales tozero working capital. As managing director EricNutter of Wabco UK, a British automotive subsidiaryof American Standard, saw it, “In business, it isn’tover till the fat lady sings, and I say she doesn’tsing till you’re at zero working capital.”

In the 2000s, retailers other than the warehouseclubs began singing the same tune. Between 2000and 2004, Tesco, the leading grocery chain in theUnited Kingdom, began stretching the payablesterms it obtained from suppliers, freeing up £2.2

billion (nearly $4 million at that time) in cash thatit could use for growth. The trend toward negativeworking capital will continue, though it will betested in the aftermath of the global credit crunchthat began in 2007.

For aspiring entrepreneurs and for businessesalready up-and-running in other more capital-intensiveindustries, a negative working capital model isworth searching and working for. It makes it easierand less costly to get into business in the first place.And it makes it much easier for your business togrow. Consumer services businesses – haircutters,landscapers, tax preparers and the like – seek andfind it by nature, since they get paid in cash andhave little need for inventory. It is no wonder thatthese some of these formerly fragmented industriesare increasingly dominated by fast-growing

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Costco also insisted that no item could be marked up to a gross margin over 14 per cent. Contrast that withsupermarkets and department stores, which carried 20 to 50 per cent gross margins.



chains, as savvy entrepreneurs have realized thatthese businesses are easy to get into and easy togrow, from a working capital perspective.

Costco offers an additional – and perhapsunexpected – lesson for aspiring entrepreneurs. Ifyou aim to start a new venture, why not do it in anindustry whose working capital requirements can bemodest – or even negative? Periodicals publishing is one example of such an industry; trade showoperators, cable television companies, payrollprocessors and other human resources outsourcersare other examples. You’ll need much less capital to get started, and less capital to grow, than in other industries.

There is more on the balance sheet that has to befunded than working capital, of course. There is therest of the investment that it takes to put a companyin business or keep it there (such as retail stores forCostco or R&D for technology or pharmaceuticalfirms). Yet in thinking about all this, one lessonshould prevail: generating the cash you need fromyour gross margin or working capital models, ratherthan from investors, the more conventional route, isimportant – and perhaps critical in a businessdownturn, one in which investors may be hoardingwhat cash they have. Moreover, who wants to give upequity to investors if you can find the cash somewhereelse? In closing, I offer four question sets that canbe your launch pad to greater cash flow throughbetter management of your working capital:

� Considering your revenue model, when (how manydays ahead of or behind delivering the goods orservices) can you encourage your customers to pay?Can you get them to pay earlier? Why or why not?

� How quickly or slowly (measured in days fromwhen the supplies are delivered or the work isperformed) must you pay key suppliers andemployees? What are the industry norms? Whymight you be able to alter them?

� How much cash (measured in days) must you tieup in inventory or other prepaid items – currentassets, in accounting lingo – before they are readyto be sold? What are the industry norms? Whymight you be able to alter them?

� Are there any leaps of faith you can identify,which if borne out in your next experiment, wouldenable you to dramatically differ, in workingcapital terms, from others in your industry? Whatare they, what are your hypotheses, and how willyou test them?

Under economic conditions such as those thatprevail today, top-line revenue is important, of course.It’s the clearest signal of what your customers thinkof your company and what it offers. But moreimportant than revenue – and more important thanprofit, too – is the all-powerful commodity calledcash. Manage your working capital better, and youwon’t run out of it. �

ResourcesJohn Mullins, The New Business Road Test: WhatEntrepreneurs and Executives Should Do BeforeWriting a Business Plan, Financial Times/PrenticeHall, 2006.

John Mullins and Randy Komisar, Getting to Plan B:Breaking Through to a Better Business Model,Harvard Business School Press, 2009.

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John W. Mullins ([email protected]) is Associate Professor of Management Practice at London Business School and holds the David and Elaine Potter Foundation Term Chair in Marketing and Entrepreneurship.

London Business School Regent’s ParkLondon NW1 4SAUnited KingdomTel +44 (0)20 7000 7000Fax +44 (0)20 7000 7001www.london.eduA Graduate School of the University of London



Seize Advantage in a Downturn

by David Rhodes and Daniel Stelter Harvard Business review

INACTION IS THE RISKIEST RESPONSE to the uncertainties of an economic crisis. But rash or scattershot action can be nearly as damaging. Rising anxiety (how much worse are things likely to get? how long is this going to last?) and the growing pressure to do something oft en produces a variety of uncoordinated moves that target the wrong problem or overshoot the right one. A disorganized response can also generate a sense of panic in an organization. And that will distract people from seeing something crucially important: the hidden but significant opportunities nestled among the bad economic news.

We offer here a rapid but measured approach -- simultaneously defensive and offensive -- to tackling the challenges posed by a downturn. Many companies are already engaged in some kind of exercise like this. Certainly every organization with an institutional pulse has held discussions focusing on what it should do about the current economic crisis. We hope this article will help you move from what may have been ad hoc conversations and initiatives to a carefully thought-out plan.

The merits of a comprehensive and aggressive approach are borne out in research by the Boston Consulting Group, which indicates that companies whose early responses to a downturn are tentative (for example, modest belt-tightening) typically overreact later on (say, cutting costs more than they ultimately need to). This results in an expensive recovery for the company when the economy rebounds.

Our approach has two main objectives, from which a series of action items devolves. First, stabilize your business, protecting it from downside risk and ensuring that it has the liquidity necessary to weather the crisis. Then, and only then, can you identify ways to capitalize on the downturn in the longer term, partly by exploiting the mistakes of less savvy rivals.

For some companies, the outcome of this process will be a program of immediate actions that represent a turbocharged version of business as usual. For others, it will be a painful realization that nothing short of an urgent corporate turnaround will suffice.

What Is Your Exposure? The first step for a company to take in a challenging economic environment -- especially one that could significantly worsen -- is to assess in a systematic manner its own vulnerabilities, at the company level and by business unit.

Consider several scenarios. As an economic crisis evolves, sketch out at least three scenarios -- a modest downturn, a more severe recession, and a full-blown depression, as defined by both duration and severity. Consider which scenario is most likely to unfold in your industry and your business, based on available data and analysis. There was evidence from the beginning, for example, that the current global downturn truly stands apart. Early on, banking losses had outstripped those of recent financial disasters, including the United States savings and loan crisis (1986--1995), the Japanese banking crisis (1990-- 1999), and the Asian financial crisis (1998--



1999). Furthermore, as the economy first began to stall, the underlying problem of consumer and corporate indebtedness -- in the United States, it totaled about 380% of GDP, nearly two and a half times the level at the beginning of the Great Depression -- pointed to a prolonged period of economic pain.

Next, determine the ways in which each of the scenarios might affect your business. How would consumers' limited capacity to borrow reduce demand for your products? Will job insecurity and deflating asset prices make even the creditworthy increasingly reluctant to take on more debt? Will reduced demand affect your ability to secure short-term financing, or will weak stock markets make it difficult to raise equity? Even if you are able to tap the debt and equity markets, will higher borrowing costs and return requirements raise your cost of capital?

Quantify the impact on your business. Run simulations for each of these scenarios that generate financial outcomes on the basis of major variables, including sales volume, prices, and variable costs. Be sure to confront head on what you see as the worst case. For example, what effect would a 20% decline in sales volume and a 5% decline in prices have on your overall financial performance? You may be surprised to find out that, even in the case of a still-healthy company with operating margins (before interest and taxes) of around 10%, such a decline in volume and prices could turn current profits into huge losses and send cash flow deep into the red. Conduct a similar analysis for each business unit.

Next, quantify how your balance sheet might be affected under the different scenarios. For example, what will the impact be of asset price deflation? To what extent might lower cash flows and the higher cost of capital affect goodwill and require write-off s on past acquisitions? Will falling commodity prices cushion some of the detrimental effects?

Assess rivals' vulnerabilities. Of course, none of this process should be carried out in a vacuum. Your industry and the locations of your operations around the world will help determine how your business will be affected. It's critical to understand your own strengths and weaknesses relative to those of your competitors. They will have different cost structures, financial positions, sourcing strategies, product mixes, customer focuses, and so on. To emerge from the downturn in a lead position, you must calibrate the actions you plan to take in light of the actions that your competitors will most likely take. For example, assess potential acquisitions with a focus on vulnerable customer groups of weaker competitors.

This assessment of different scenarios and their effects on your company and its rivals, while just a first step, will help you identify particular areas where you're vulnerable and where action is most immediately needed. This analysis will also help you to communicate to the entire organization the justification and the motivation for actions you'll need to take in response to the crisis.



How Can You Reduce Your Exposure? Once you understand how your business could be affected, you need to figure out the best way to survive and maximize your company's performance during the downturn. This requires achieving several broad objectives.

Protect the financial fundamentals. The aim here is to ensure that your company has adequate cash flow and access to capital. Not only does a lack of liquidity create immediate problems but it also is critically important to your ability to make smart investments in the future of the business.

Consequently, you need to monitor and maximize your cash position, by using a disciplined cash management system, by reducing or postponing spending, and by focusing on cash inflow. Produce a rolling report on your cash position (either weekly or monthly, depending on the volatility of your business) that details expected near-term payments and receipts. Also estimate how your cash position is likely to evolve in the midterm, calculating expected cash inflows and outflows. You may need to establish a centralized cash management system that provides companywide data and enables pooling of cash across business units.

How much spending you postpone depends on your assumptions about the severity of the downturn and to what degree such spending is discretionary. But you'll want to be just as aggressive in looking for ways to improve cash flow -- if you were facing a worst-case-scenario liquidity crisis, for example, just how much cash would you be able to raise during the next quarter?

One way to improve cash flow is to more aggressively manage customer credit risk. Trade credit -- financing your customers' purchases by letting them pay over time -- should be reduced where possible. Given the economic environment, buyers will seek credit more frequently and your risk will increase. You'll need to segment your customers by assigning them each a credit rating. Avoid granting trade credit to higher-risk customers or to those whose business is less strategically important to you. Also, assess the trade-off between credit risks and the revenue potential of a marginal sale. This will require cooperation between people in sales and customer finance, as well as a review of those employees' incentives to make sure they're aligned with revised strategic goals for the downturn.

Another way to free up cash is to look for opportunities to reduce working capital. A surprisingly large number of companies are unaware of the benefits of aggressively managing their working capital -- the difference between a company's current assets and liabilities -- and thus make little effort to even monitor it. As a rule of thumb, most manufacturing companies can free up cash equivalent to approximately 10% of sales by optimizing their working capital. This involves reducing current assets, such as inventories (through more careful management of both production and sourcing processes) and receivables (through, in part, the active management of trade credit).

As you scrutinize your customers' debt profiles, you should review your own as well, in order to optimize your financial structure and financing options. The heyday of leverage, with constant pressure from the market to operate with relatively low levels of equity, is clearly over for now.



You should be looking for ways to strengthen your balance sheet, reducing debt and other liabilities, such as operating leases or pension obligations, with the dual aim of reducing your financial risk and enhancing your risk profile in the eyes of investors.

Be sure, as well, to secure financing -- for example, draw on lines of credit as soon as possible to provide liquidity for day-to-day operations, holding onto any excess cash to avoid refinancing problems in the future. Meeting such needs may require some creativity in a tight credit market. For example, some companies, in renewing revolving credit facilities with banks, have agreed to forgo fixed interest rates on the funds they draw down under the facility. Instead, borrowers have agreed to link the rate to the trading price of their so-called credit default swaps. These financial instruments, which represent a form of insurance against a borrower defaulting, reflect the market's perception of a company's creditworthiness. By agreeing to initially high and variable interest rates for a line of credit, borrowing companies can secure access to funds at a time when skittish banks are reluctant to lend. To secure equity capital, companies need to look beyond the market to sources such as sovereign wealth funds, private equity firms, or cash-rich investors.

Protect the existing business. After ensuring that the company is on a firm financial footing, turn to protecting the viability of the business. You must be prepared to act quickly and decisively to improve core operations.

Begin with aggressive moves to reduce costs and increase efficiency. Although cost-cutting is the first thing most companies think about, their actions are oft en tentative and conservative. You need to work rapidly to implement measures, using the turbulent economic environment to catalyze action that is long overdue -- or to revive earlier initiatives that proved too controversial to fully implement in good times. Keep in mind, though, that while speed is important so is a well-reasoned plan: You don't want to make cuts that in the long term will hurt more than they help by, for example, putting important future business opportunities at risk.

Some means of streamlining the organization and lowering break-even points are obvious: stripping out layers of the organizational hierarchy to reduce head count, consolidating or centralizing key functions, discontinuing long-standing but low-value-added activities. SG&A expenses -- selling, general, and administrative costs, such as marketing -- are also prime targets for cost-cutting. As such, they can highlight the risks of purely reactive action: Companies that injudiciously slash marketing spending oft en find that they later must spend far more than they saved in order to recover from their prolonged absence from the media landscape.

Opportunities to reduce materials and supply chain costs also arise in a downturn. Now is the time to pursue a comprehensive review of your current suppliers and procurement practices, which undoubtedly will prompt new initiatives -- the adoption of a demand management system, say, or the standardization of components. In particular, consider how the downturn affects the economic equation of off shore manufacturing. Falling shipping costs could make off shoring more attractive, even for low-cost items; at the same time, a weakening domestic currency, trade barriers, and especially the cash tied up in the additional working capital required to source a product far from its market may off set any savings.



While looking for opportunities to reduce spending, you'll also want to aggressively manage the top line, cash being crucially important in a recession. Actively work both to protect existing revenue and identify ways to generate additional revenue from your current business. Customer retention initiatives become more valuable than ever. Consider tactical changes in sales force utilization and incentives. Reallocate marketing spending to bolster immediate revenue generation rather than longer-term brand building. While granting trade credit sparingly, also consider the possible benefits of offering customers more-generous financial terms while charging them higher prices -- provided you've done your homework on your own financial structure.

As these initiatives suggest, you'll want to rethink your product mix and pricing strategies in response to shifting customer needs. Purchasing behavior changes dramatically in a recession. Consumers increasingly opt for lower-priced alternatives to their usual purchases, trading down to buy private label products or to shop at discount retailers. Although some consumers will continue to trade up, they'll do so in smaller numbers and in fewer categories. Consumer products companies should consider offering low-priced versions of popular products -- think of the McDonald's Dollar Menu in the United States or Danone's Eco-Pack yogurt in France. Whatever your business, determine how the needs, preferences, and spending patterns of your customers, whether consumer or corporate, are affected by the economic climate. For example, careful segmentation may reveal products primarily purchased by people still willing to pay full price. Use that intelligence to inform product portfolio and investment choices.

Innovative pricing strategies may also alleviate downward pressure on revenue. These include: results-based pricing, a concept pioneered by consulting firms that links payment to measurable customer benefits resulting from use of a product or service; changes in the pricing basis that would allow a customer to, for example, rent equipment by the hour rather than by the day; subscription pricing, by which a customer purchases use of a product -- say, a machine tool -- rather than the product itself; and the unbundling of a service so that customers pay separately for different elements of what was previously an all-in-one package, as airlines have done with checked baggage and in-flight meals and entertainment. Offering consumers new and creative customer financing packages could tip the balance in favor of a sale. It was during the Great Depression, after all, that GE developed its innovative strategy of financing customers' refrigerator purchases.

You should definitely rein in your investment program. Most developed economies had excess capacity even before the downturn: Capacity utilization in the United States, for example, fell below 80% of potential output beginning in April 2008. In the current economy, there is even less need, in most industries, to invest in further capacity. You need to establish stringent capital allocation guidelines aligned with the current economic climate, if you haven't already. This may also be the time to shed unproductive assets, including manufacturing plants that have previously been difficult to shut down, selling them where possible to generate cash for the business.

Finally, take this opportunity to divest noncore businesses, selling off peripheral or poorly performing operations. Don't wait for better times, in the hope of getting a price that matches those of recent years, when the economy was buoyant and credit was plentiful. Those conditions



aren't likely to return anytime soon, and if the business isn't critical to your activities and increases your vulnerability to the downturn, divest it now.

Research by our firm shows a strongly positive market reaction to the right divestitures in recessionary times. And shedding noncore operations ideally will end up energizing your core business. In 2003, in the middle of a particularly acute economic downturn in Germany, MG Technologies, a €6.4 billion engineering and chemicals company, decided to focus on its specialty mechanical engineering business. It sold its noncore chemical and plant engineering businesses and emerged as the renamed GEA Group, a slimmed down but successful specialty process engineering and equipment company, better positioned to pursue growth opportunities in its core areas.

Maximize your valuation relative to rivals. Your company's share price, like that of most firms, will take a beating during a downturn. While you may not be able to prevent it from dropping in absolute terms, you want it to remain strong compared with others in your industry. Much of what you've done to protect the financial fundamentals of your business will serve you well. In a downturn, our data shows that markets typically reward a strong balance sheet with low debt levels and secured access to capital. Instead of being punished by activist investors and becoming a takeover target for hedge funds, a company sitting on a pile of cash is viewed positively by investors as a stable investment with lower perceived risk. For that to happen, you need to create a compelling investor communications strategy that highlights such drivers of relative valuation. This will also be important as you try to capitalize on the competitive opportunities that a recession offers, such as seeking attractive mergers and acquisitions.

You can further enhance your relative value if you reassess your dividend policy and share buyback plans. A Boston Consulting Group study of U.S. public companies found that, on average, investors favor dividends because they represent a much stronger financial commitment to investors than buybacks, which can be stopped at any time without serious consequences. On average, sustained dividend increases of 25% or more overwhelmingly resulted in higher relative valuation multiples in the two quarters following their announcement. By contrast, buybacks had almost no impact on the relative valuation multiple in the two quarters following the transaction. For example, TJX Companies, a U.S. discount retailer, announced a dividend increase of 33% in June 2002, when the country was in a recession -- and then enjoyed a price-to-earnings multiple 42% higher than the average of S&P 500 companies over the two quarters following the announcement. These are exceptional times, though, and we recommend that companies analyze their particular situation as well as investor preferences before taking a specific measure.

How Can You Gain Long-Term Advantage? The best companies do more than survive a downturn. They position themselves to thrive during the subsequent upturn, guided again by a number of broad objectives.

Invest for the future. Investments made today in areas such as product development and information or production technology will, in many cases, bear fruit only after the recession is past. Waiting to move forward with such investments may compromise your ability to capitalize on opportunities when the economy rebounds. And the cost of these investments will be lower now, as competition for resources slackens.



Given current financial constraints, you won't be able to do everything, of course, or even most things. But that shouldn't keep you from making some big bets. Prioritize the different options, protecting investments likely to have a major impact on the long-term health of the company, delaying ones with less-certain positive outcomes, and ditching those projects that would be nice to have but aren't crucial to future success.

Sanofi-Synthélabo, the French pharmaceutical company, entered the economic recession that began in 2001 with a solid product portfolio. Throughout the downturn, the company maintained, and in some cases increased, its R&D spending in order to keep its product pipeline robust. Sanofi increased its absolute R&D expenditure from €950,000 in 2000 to €1.3 million in 2003. Because of its strong business and financial performance, the company gained market share and outperformed peers in the stock market. The company was thus well positioned to acquire Aventis, a much larger Franco-German pharmaceutical company, after a takeover battle, in the economic upswing of 2004.

Or look at Apple Computer. The company wasn't in particularly good shape as it headed into the 2001--2003 recession. For one thing, revenue fell 33% in 2001 over the previous year. Nonetheless, Apple increased its R&D expenditures by 13% in 2001 -- to roughly 8% of sales from less than 5% in 2000 -- and maintained that level in the following two years. The result: Apple introduced the iTunes music store and software in 2003 and the iPod Mini and the iPod Photo in 2004, setting off a period of rapid growth for the company.

A downturn is also a good time to invest in people -- for example, to upgrade the quality of your management teams. Competition for top people will be less fierce, availability higher, and the cost correspondingly lower.

Pursue opportunistic and transformative M&A. The recession will change several of the long-standing rules of the game in many industries. Exploit your competitors' vulnerabilities to redefine your industry through consolidation. History shows that the best deals are made in downturns. According to research by our firm, downturn mergers generate about 15% more value, as measured by total shareholder return, than boom-time mergers, which on average exhibit negative TSR.

To capitalize on opportunities, closely monitor the financial and operational health of your competitors. Companies lacking the financial cushion to benefit from the recession -- or even to stay afloat -- may even welcome your advances.

In late 2001, only weeks after the 9/11 terrorist attacks had brought vacation travel to a near standstill, Carnival, the world's largest cruise ship operator, interceded in the planned friendly merger of Royal Caribbean and P&O Princess Cruises, then the second and third largest cruise operations respectively. Its own bid to acquire P&O Princess required persistence -- it was 15 months before P&O Princess shareholders finally accepted Carnival's offer -- but the deal turned out to be a smart strategic move for the company, whose total shareholder returns far surpassed those of the S&P 500 in the years following the announcement and then the completion of the acquisition.



Of course, you'll have to ride out the recession carrying the baggage of any company you acquire, so due diligence -- particularly concerning a potential target's current and future cash positions -- takes on even more importance during a downturn. This knowledge will help you to limit the particular risks arising from an acquisition made during a recession, as well as to convince your management teams and supervisory boards that a bold move during a period of caution makes sense.

Rethink your business models. Downturns can be a time of wrenching transformation for companies and industries. The economics of the business may change because of increased competition, changing input costs, government intervention, or new trade policies. New competitors and business models may emerge as companies seek to increase revenue through expansion into adjacent product categories or horizontal integration. Successful companies will anticipate these changes to the industry landscape and adapt their business models ahead of the competition to protect the existing business and to gain advantage.

Consider IBM. During the U.S. recession of the early 1990s, the company under Lou Gerstner faced its first decline in revenue since 1940 and endured successive years of record losses. In this context, it began to rethink its business model. Struggling with sluggish economic growth, particularly in Europe and Japan, as well as increased price competition, IBM was forced to confront head on the inevitable decline of its traditional business, mainframe computers. Realizing that the company's markets were shifting, Gerstner redefined the company's business model, transforming IBM from a hardware producer into a computer services and solutions provider.

Where Do You Take Action?

The process we have laid out should yield a list of promising initiatives -- undoubtedly more of them than you'll have the capacity to launch and manage all at once. So you'll need to prioritize, carefully assessing each initiative based on several criteria -- most notably, urgency, overall financial impact, barriers to implementation, and risks that the initiative might pose for the business. The result will be a portfolio of actions with the right blend of short-term and long-term focus.

Who is going to carry out the recession plan? We recommend that you form a dedicated crisis management team to manage your organization's response to the recession. The team will develop different economic scenarios and determine how they might affect the business; identify recession-related risks and opportunities; and prioritize initiatives designed to mitigate the risks and capitalize on the opportunities. It will then oversee implementation of the initiatives, monitoring their progress and continually reevaluating them in the light of changes in the economic landscape. (For a summary of how the crisis management team can help ensure a recession plan's success, see the sidebar "Avoiding the Snags of Implementation.")

Companies adopting the comprehensive approach we have laid out will be not only better placed to weather the current storm but also primed to seize the opportunities emerging from the turbulence and to get a head start on the competition as the dark clouds begin to disperse.



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Late-paying clients, slashed credit lines and tightened terms are the realities for today’ssmall- and mid-sized entities as they scramble tosurvive in the strugglingeconomic recovery.

MMike Smith, who took over his fam-

ily’s Houston-area trucking busi-

ness several years ago, says that he’s

being financially whipsawed.

His small company, K-Mac Vacu-

um Truck Service, based in Alvin,

Texas (about 45 minutes southeast

of Houston), operates five trucks

that provide waste-hauling and

cleaning services to some 30 oil-

drilling concerns. Recently, howev-

er, his customers have grown

increasingly balky at meeting their

obligations. Clients who used to pay

their bills in 30 days are now

taking 60 days, while those

who used to pay in 60 days

are delaying payments for

90 days. “Getting paid,” Smith says,

“is my biggest problem.”

And that has reverberations. It

means that Smith is unable to pay in

a timely manner all but the most

urgently pressing of his bills. “I’m

getting lots of phone calls from peo-

ple wanting their money,” he says.

“But if I’m not getting paid, I can’t

pay them.”

At the same time, Smith says, his

bank has reduced his line of credit.

What has happened, he says, is that

his financial institution is basing

this year’s line of credit on perform-

ance numbers from recessionary

2009, when revenues fell to less than

$1 million from a robust $1.8 million

in sales in 2008 (when oil prices

were shooting through the roof).

Not getting paid for accounts

receivable? Banks and financiers

cutting back — or completely elimi-

nating — loan amounts and lines of

credit? Smith’s lament is being

repeated across the country at

offices, stores, manufacturers, ware-

houses and other worksites of small

businesses and medium-sized com-

panies, which form the bulk of Unit-

BY PAUL SWEENEY

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ed States commerce and industry. In

turn, the phenomenon is wreaking hav-

oc with the fledgling U.S. economic

recovery as it tries to put the darkest

days of 2008-09, sometimes called the

great recession, behind it.

There are a fortunate few exempt

from the current economic bind.

According to the U.S. Federal Reserve,

the 500 largest U.S. corporations were

holding $1.8 trillion in cash reserves at

mid-year 2010.

But for a significant chunk of the

small- and medium-sized enterprises

(SMEs) — which account for a “dispro-

portionately large share of new jobs” in

the U.S., according to an analysis by the

Organization for Economic Cooperation

and Development — maintaining work-

ing capital in the form of earned rev-

enues and financings remains a signifi-

cant challenge.

As finances tighten, SMEs are cutting

costs and formulating survival strate-

gies. The U.S. Small Business Adminis-

tration defines a small business as a usu-

ally privately owned business with few-

er than 500 employees and less than $10

million in sales. Medium-sized compa-

nies are an even more amorphous

group, since definitions differ; BDO

partner Mat Wood says that would

include companies with $25 million to

$250 million in sales revenues.

“Everyone is going in the same direc-

tion,” says Wood, a partner in transaction

advisory services at BDO, an accounting

and professional services firm. “Every-

one is trying to collect as much cash as

possible while stretching out payables.

On things like inventory, over which

businesses have some control, they are

running as lean as possible.”

Bill Dunkelberg, chief economist at

the National Federation of Independent

Business, said in a July interview that,

according to the latest survey by his

organization, 42 percent of small busi-




nesses reported that they were

being paid more slowly; a scant 1

percent reported getting paid more

quickly. At the same time, 22 per-

cent reported that they themselves

were taking longer to pay their bills;

only 4 percent said they were pay-

ing faster.

The National Small Business

Association reports that, in its July,

survey of 400 businesses, those

reporting that they had “adequate”

business financing had plunged to

59 percent, a striking decline from

the 78 percent that reported having

sufficient capital in mid-year 2008.

“Although a majority are able to

secure financing,” the NSBA report

states, “it cannot be glossed over

that 41 percent of the nation’s small

businesses — which translates into

more than 12 million [business-

es] — are not able to get adequate

financing.”

Moreover, NFIB’s Dunkelberg

reports, 16 percent of retailers that

rely on trade credit from vendors

report that terms have tightened

compared with a year earlier. An

arrangement used by “thousands of

different businesses ranging from

restaurants to plumbers,” he says,

purchase goods or services on

account, trade credit is reportedly

the second-highest source of entre-

preneurial financing after banks.

“If Staples used to allow you 30

days to pay for your stationery,”

Dunkelberg says by way of exam-

ple, “now it’s 15 days.” (If a busi-

ness violates the agreed-upon

terms, it typically results in penal-

ties and extra costs.)

Alternative Financing Options

The smaller businesses are cutting

costs, turning to family and friends

and dipping into savings while

beating the bushes for alternative

financing sources. Among the

financing options: They are increas-

ingly enlisting factoring agents and

asset-backed lenders that will make

loans secured by inventory or plant

and equipment. Still other business-

es are looking to non-bank sources

of capital.

Sensing opportunity, a new

breed of financiers — who are likely

to charge premium rates for the use

of their capital — are filling the

void. But more often than not, these

specialty lenders operate in niche

markets, lending to sophisticated

entrepreneurs with a track record at

developing cutting-edge technolo-

gies in software or alternative ener-

gy or in tried-and-true sectors such

as health-care services and medical

devices.

Smith, the Houston-area trucking

entrepreneur, has engaged a factor-

ing service that advances him 80 per-

cent of the value of accounts receiv-

able but takes a 10-percent cut. He

also operates a financial services and

investment firm (Smith only recently

inherited the family trucking busi-

ness, he says) and has been lending it

money. “I’ve become my own bank,”

he says.

Some small businesses report

that they’ve completely lost their

bank financing. Eric Donaldson,

owner of Hot Shot Delivery — a

Houston courier service sometimes

described as “Federal Express on

steroids” — says that the company

foundered after Hurricane Ike in

September 2008. And that was fol-

lowed by the “tough year” in 2009,

he says, when Donaldson saw the

business go from a strong cash posi-

tion to tapping into its $100,000 line

of credit, which has since been

yanked. Since he repaid all bank

borrowings, he says, he has been

unable to recruit a replacement.

“Finding a new banker has been

almost impossible,” says Donald-

son. “The bank four blocks away

from my house is happy to take my

$285,000-a-month in deposits but

won’t give me a $50,000 line of cred-

it. The best offer I’ve gotten so far is

a Business MasterCard with a

$40,000 limit and probably 12-13

percent interest.”

He’s been able to survive largely

by cutting costs, including a 30-per-

cent pay cut for himself, and trim-

ming fulltime staff by roughly a

third to 13 from 19, mainly by attri-

tion. He still employs 75 independ-

ent contractors. Meanwhile, Don-

aldson has been asking cus-

tomers — his courier service counts

government agencies, law and

architectural firms, and hospitals

and clinics among his top clients —

to pay with a credit card in return

for a discount.

“A lot of the lawyers and archi-

tects say they’re having trouble get-

ting paid,” he says. “So if they’re

paying by credit card and their

American Express bill is due on the

seventh day of the month, I bill

them on the eighth. This way, I’m

still getting my money and they get

an extra month to pay their credit

card company.”

financial executive | october 2010 www.financialexecutives.org46

Smaller businesses are cutting costs, turning to family

and friends and dipping into savings while beating the

bushes for alternative financing sources. Among the

financing options, they’re enlisting factoring agents

and asset-backed lenders that will make loans secured

by inventory or plant and equipment. Others are

looking to non-bank sources of capital.




What About Bank Lending?

To be sure, bankers are not with-

holding financing out of spite or

malice. James Lundy, president of

Alliance Bank of Arizona, a

Phoenix-based institution with $1.3

billion in assets, reports that, among

other things, banks are in a bind

with government regulators after

the meltdown of the housing indus-

try and the near-collapse of the

financial system two years ago.

So while they are being urged to

lend more money to small business-

es and entrepreneurs by the current

administration and Federal Reserve

Chairman Ben Bernanke, they face

stiffer capital requirements from

regulators. “We are expanding our

loans,” he says, “but we’re probably

the exception.”

The difficulty faced by most

commercial banks, he notes, is that

much of the commercial lending to

SMEs in recent years was actually

a thinly disguised real-estate loan.

“In the past,” Lundy says, “a huge

part of a loan for $250,000 was not

based on analyzing the restaurant

or even a lawyer ’s practice. It was

based on the $300,000 in equity

that they had in their house. It was

really just a dressed-up home-

equity loan.”

Charles Wendel, president of

Financial Institutions Consulting,

says that big money-center and

conglomerate banks in particular

are shunning small business lend-

ing. “They’ll say that they love

small business and entrepreneurs

because the government is breath-

ing down their necks,” he says,

“but when push comes to shove,

they’re not backing it up. Unless

you have the streamlined internal

processes in place, it’s very difficult

to make money.”

Ethne Swartz, an associate pro-

fessor at Fairleigh Dickinson Uni-

versity who chairs the Marketing

and Entrepreneurial Studies pro-

gram at its Silberman College of

Business, says, “One of the unfortu-

nate things that has happened since

the late 1990s is that banks did grow

very large. Most of the credit deci-

sions are computer-generated now

rather than made by a local banker

who has become familiar with an

industry and makes decisions based

on the company itself and how it

was run historically.”

Swartz urges entrepreneurs to

forge ties with regional and local

banks and, similarly, to develop

closer working relationships with

late-paying customers.

Alternative sources such as fac-

toring are another financing option,

although she notes that using such

agents can be both pricey and, while

accepted in the retail trade, often

carry a stigma elsewhere.

But even bigger players are feel-

ing the pinch, reports Bryant Riley,

founder and chairman of Los Ange-

les investment bank B. Riley & Co.,

which specializes in raising capital

for middle-market companies.

He reports that one client, the

Oxnard, Calif.-based wireless serv-

ices provider CalAmp Corp., had its

senior debt facility slashed from $20

million to $10 million last year and

turned to the capital markets for

some $8 million in subordinated

debt and a follow-on equity offering

of about $5 million. The bottom line,

he notes, was that 6-percent senior

bank debt was replaced with more

costly debentures bearing a 12-per-

cent coupon and financing from a

dilutive stock offering.

Why the more expensive debt

and equity? After all, CalAmp had

been narrowing its losses and its

prospects have been markedly

improving; in the fourth quarter of

fiscal 2010, it reported a 62-percent

increase in year-over-year quarterly

revenues to $32.5 million. “It’s just

harder to get working capital,”

Riley says. “There are fewer lenders

and everybody is more conservative

and risk averse.”

Gary Reagan, senior vice presi-

dent at Comerica Bank who leads a

Los Angeles-area group that lends

to middle-market companies in the

technology and life sciences sectors,

works closely with venture capital-

ists in helping emerging growth

companies find working capital.

Solid companies are still getting

loans, he says, but for many middle-

market companies still struggling to

shake off the recession, he says, the

bank “works them out to alternative

lenders.”

Which could lead a Web-based

company to call someone like Jed

Simon at Fast Pay Partners, a Los

Angeles-based specialty lender.

Simon, a former Morgan Stanley

investment banker in its media and

entertainment division, explains

that his firm purchases receivables

from digital-media publishing com-

panies dependent on online adver-

tising revenues. Shunning the label

“factoring agent,” Simon describes

his seven-month-old firm’s business

as “receivables financing.”

Fast Pay only accepts receivables

from high-quality companies —

advertisers like University of Phoenix,

Gillette, Gatorade and such well-

known advertising agencies as

Omnicom, Publicis Groupe or WPP.

Clients must have $10,000 to qualify

for his services, according to the firm’s

Web site, which pay 70-80 percent of

the receivables value up front.

“In the past economic cycle,”

Simon says, “payment terms for

online advertising — which have

always been long — have extended

literally to the breaking point. From

45 days,” he adds, “it’s gone to 60,

90 and even beyond 120 days, and

(the lack of working capital) has

reverberated throughout the online

publishing ecosystem. Gatorade

pays the media buyer, who pays the

advertising network, who pays the

publisher. When any part of that

goes down, the impact is felt

throughout.”

After only six months, the firm had

deployed about $2 million to clients,

and he is upbeat about future

prospects. “Our target market in

online media is growing,” he says.

“and it is heavily under-banked.”

PAUL SWEENEY ([email protected]) is

an Austin-based freelance writer who

contributes frequently to Financial Exec-

utive on issues pertaining to finance, cor-

porate ethics and governance.

www.financialexecutives.org october 2010 | financial executive 47




Managing Working Capital to Survive the Downturn

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