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Treasury Owns Working Capital: Leading Practices Part 8

This is the eighth topic and ninth article in a series on leading practices in corporate treasury.

In a previous article in this series, we discussed the meaning and importance of treasury owning cash. Another leading practice for treasury is the application of this same principle of ownership to working capital.

What do we mean by “working capital”?

Working capital has two different definitions – a “traditional” definition as well as “net adjusted” working capital. Both are useful and “correct,” but they are suited to different purposes. Each definition can be expressed as a formula, and each is used by different groups:

1. Traditional definition: Working capital = current assets – current liabilities

This definition is particularly useful to accountants and bankers. It can be easily calculated by anyone with access to the balance sheet, and it gives important insight into a company’s ability to meet current obligations. However, this is not the formula that treasury finds most useful.

2. Net adjusted working capital: Working capital = accounts receivable + inventory – accounts payable

This definition and formula for working capital shows treasury a summary of what is happening with the components of the cash conversion cycle. It allows treasury to view the impacts of shifting speeds in converting receivables to cash.

 In this article, we are discussing net adjusted working capital and advocating for treasury taking responsibility for its management. By this we mean that treasury owns working capital. For the rest of the article, you may assume that “working capital” refers to treasury’s net adjusted definition. Keep in mind, however, that it is important for treasury staff to understand both definitions so that they can communicate effectively with other areas of the business.

Treasury’s responsibility

Working capital is an area where careful oversight and leadership can make a significant improvement, not only for individual departments, but also for the organization at large. It has a definite impact on organizational value, and with so many areas involved, its management – or mismanagement – leads to chain reactions across the company. As a result, no highly excellent company neglects the intentional and thoughtful management of its working capital.

With several areas such as AP and AR directly involved in working capital, it may seem strange to call it treasury’s responsibility. After all, treasury is hardly involved (directly, at least) in the components that control it.

Working capital management, however, requires a broad perspective that takes into account quite a number of different factors and is able to remain focused on the bigger picture. Treasury, with a broad view of the company’s situation and a finger on the pulse of overarching organizational goals and needs, is ideally suited to take ownership of this area. In addition, its wide-ranging impacts on the company’s assets, profitability and valuation mean that treasury is not only in the ideal position to take ownership of working capital, but also has a responsibility to do so.

In order to carry out this responsibility and properly take ownership of working capital, treasury must understand the need to optimize working capital and must bring together the other areas involved to weed out competing key performance indicators (KPIs) and work together towards a common goal.

Step 1: Don’t minimize or maximize – optimize working capital

Neither minimizing nor maximizing are proper goals when it comes to working capital. Rather, the goal is to bring working capital to an optimal level. Optimize working capital.

That level will look different for different organizations at different times. Generally speaking, however, optimal working capital is a level that is high enough to accommodate the operations and outcomes needed by various departments, and – since high working capital can negatively impact organizational value – no higher. Digging into the details and impacts and discovering what the optimal level needs to be and how to achieve it requires the working capital council.

The Working Capital Council

With three different areas in the formula itself (AR, inventory and AP) and many more that either impact or are impacted by it, working capital is a complex area. Managing it requires a significant amount of teamwork among groups that are typically plagued by competing KPIs. These competing KPIs are metrics that narrowly define a department’s own goals while unintentionally impeding the goals of other departments and, ultimately, of the organization at large.

As long as competing KPIs are present, and these departments are failing to support each other’s and the company’s goals alongside their own, working capital will not be optimized. The first step, then, is to bring these units together and start working toward a united front with common ultimate goals.

The leading practice for approaching this is to form a working capital council. The council should be led by treasury, and members include areas such as AP, AR, procurement, accounting and legal/tax. Its goal is to provide a space for discussing each group’s needs and goals, understanding how each group’s operations and processes impact the others and the overarching organization, and driving out competing KPIs to make room for agreed-upon KPIs and working capital goals.

Using Your Working Capital Council

Once you’ve brought your members together and formed your council, there are several steps the council must take in order to manage working capital properly. Leading the council in these steps is part of treasury’s role as owner of working capital.

1. Make sure all parties are heard and understood. With such different goals and, very often, a history of competing KPIs that cause each other difficulties, it’s possible you will encounter some conflict and even ill-will between these departments at times. What you will almost certainly encounter, however, is a lack of full comprehension of the concerns, considerations and needs of each department.

As the owner of working capital, treasury should ensure, through careful listening and patient communication, that each party’s goals and concerns are understood by the group. Remember that communication is a process, not an event. These departments’ viewpoints may be very foreign to each other (your viewpoint may be foreign to many of them as well), and few will really take in a foreign concept the first time you explain it.

In addition to ensuring that the council participants come to a good understanding of each other’s perspectives, treasury should make sure that those impacted but not present are considered by the council. This includes both internal business units as well as customers and external partners. Many working capital initiatives can impact vendors, for example, and this impact should be taken into account in the council’s discussions.

2. Establish a single set of KPIs. Step 1 is likely to bring to light a number of competing KPIs. Keep in mind that KPIs can be problematic not only through impeding other departments, but also through failing to support overarching organizational goals.

Identify competing KPIs and thoroughly eliminate them. In their place, work with the council to establish a single set of agreed-upon KPIs that support each group’s goals and help each group support organizational goals.

3. Agree on objectives for working capital initiatives. With the groundwork above laid, the council can get down to the business of managing working capital. This may involve deciding on working capital initiatives, and these initiatives can be given their own specific objectives. Like the new KPIs, these objectives can help clarify the ultimate goal of the initiative, preventing overly narrow or misdirected efforts.

4. Reassess and adjust as needed. Despite the council’s best efforts, you may not get everything just right the first time, and new problems may crop up with the new KPIs or working capital initiatives. Even if not, changing circumstances may require adjustment. With the council, assess progress, monitor impacts, and readjust as you find areas that are not benefiting or where something could be improved. Keep working with your council to bring your working capital to optimal levels for balancing departmental needs and organizational value.

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