THE PRESSING ISSUE OF WORKING CAPITAL

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1 THE PRESSING ISSUE OF WORKING CAPITAL Different strategies are needed By Professor Ralf Seifert and Daniel Seifert, Research Assistant, EPFL, Lausanne - December 2008 IMD Chemin de Bellerive 23 PO Box 915, CH-1001 Lausanne Switzerland Tel: Fax:

2 As the global financial crisis deepens and banks tighten up on credit, working capital has become a pressing issue. IMD Professor Ralf Seifert and EPFL s Daniel Seifert question the traditional approach of squeezing suppliers and suggest instead that companies build a portfolio of strategies. Recent press reports indicate that suppliers to German car manufacturers are being pushed to the brink of bankruptcy as the country s banks withdraw or tighten their criteria on credit. It s the same in the US. With the financial community fast losing confidence in its major auto makers, parts suppliers are struggling to secure funding and are suffering at the hands of tight credit markets and a decline in demand. None of which is good news for the manufacturers who risk production stoppages as suppliers struggle to make good on timely deliveries. In the steel sector, manufacturers are reported to be re-negotiating contracts with their rawmaterial suppliers as demand in the construction and automotive industry slows. In some cases customers are said to be asking suppliers to delay or even cancel deliveries while some switch to buying their raw materials on the spot market where prices have fallen dramatically. Trade credit the lubricant of the global economy Credit is hard to come by these days. In the US, firms generate more than 15% of their financing from accounts payable. Internationally, these levels can be even higher. And since more than 80% of transactions are vendor financed, parts makers and other companies are rightfully worried about getting paid. After all, these companies have to bear the costs until the customer pays. This financial gap is known as net trade credit, which, together with inventory, forms the major component of working capital. The latter is a significant driver of profitability. In an average company, decreasing working capital by 30% leads to a 16% increase in after-tax returns on invested capital. No wonder then that Deutsche Post has announced a program to reduce working capital by 700 million by the end of And retailer Tesco has long managed to push trade credit below zero by ensuring payment from its customers before it pays suppliers. IMD - THE PRESSING ISSUE OF WORKING CAPITAL Page 2/5

3 Squeezing suppliers a sensible strategy? But it is questionable whether the right approach is to "squeeze" your suppliers. First, payment processes and trade credit vary across countries, industries and even companies. While firms generally adhere to industry norms, credit terms may vary from customer to customer. Indeed one of the managers we interviewed for this article discovered his firm had over 1,000 different credit terms globally. In many instances, firms accumulate payment terms as they add supply chain partners and do not consolidate them regularly. Financial researchers have investigated these differences and the main reasons that companies offer trade credit appear to be competitive pressure, credit information and price discrimination on the supply side, and transaction pooling, control protection and credit rationing on the demand side. Credit rationing in particular appears to be a strong argument against uniformly reducing credit. With some customers more credit constrained than others, trade credit is a greater purchasing incentive than an equivalent price reduction. Second, trade credit impacts supply chain relations and managing it aggressively might damage these relations. Companies that antagonize suppliers by paying late not only risk missing out on innovations and losing capacity, but also risk supply chain disruptions. This can impact the financial bottom line. Publicly traded firms experiencing supply chain disruptions have reported negative stock market reactions to such announcements, with market capitalization going down by as much as 10%. Three trade credit strategies Given the risk of damaging sales and relations, companies should consider a differentiated approach to managing trade credit. And while our interviews indicate that roughly two-thirds of companies still apply a single trade credit strategy, building a strategy portfolio is quite straightforward. A series of three questions can help: 1. First, managers should think about what kind of relationship they want to build. Is the supplier a strategic partner? Is the customer a key account? Will this partner be around IMD - THE PRESSING ISSUE OF WORKING CAPITAL Page 3/5

4 for more than a year? If there are likely to be repeated interactions, take the time to understand the partner s cost of capital and try to create win-win situations. 2. If the relationship is of a more transactional nature, managers should determine their company s competitive position. Are the company s goods or services innovative and unique? Has the company done well in past negotiations? If the answer is no, then there is little margin for actively shaping credit terms. The negotiation should be based on industry-standard terms. 3. Even if the company is in a strong position, it should still consider its cost base. What proportion of costs varies with production? If most costs are fixed, companies should nevertheless rely on trade credit to entice customers. If costs are mostly variable and the company can risk losing the sale, it should minimize its working capital and squeeze. In the short term, a few immediate steps should help prevent companies becoming victims of the financial crisis: Monitoring actual payments and deviations from agreed credit terms Assessing key suppliers and customers financial situations Offering liquidity in selected cases. Reaching out in times of crisis and engaging in dialogue will not only ward off disruptions but will also generate goodwill and underline interest in the relationship worth far more in the long run than simply saving cash. Professor Seifert is Director of the Mastering Technology Enterprise program. He also teaches on the Advanced Strategic Management, Managing the Global Supply Chain and the Orchestrating Winning Performance programs. Daniel Seifert is a Research Assistant at the Ecole Polytechnique Fédérale de Lausanne Ralf Seifert and Daniel Seifert examine this subject in more detail in IMD s "Perspectives for Managers" series PFM No. 166, November IMD - THE PRESSING ISSUE OF WORKING CAPITAL Page 4/5

5 RELATED PROGRAMS MANAGING THE GLOBAL SUPPLY CHAIN - Growth through productivity and efficiency Program Directors Carlos Cordon and Gabriel Bitran - Map and manage the links and risks in the extended supply chain - Challenge atomization and look at collaboration and various forms of integration - Orchestrate the balance of power and behaviors to drive the extended enterprise MASTERING TECHNOLOGY ENTERPRISE - Preparing Technical Managers for the Challenges of General Management Program Director Ralf W. Seifert Gain a deeper understanding of the business functions, processes and challenges facing the technology enterprise Grow personally, develop your leadership potential, boost your self-confidence and learn how to use cutting-edge management tools IMD - THE PRESSING ISSUE OF WORKING CAPITAL Page 5/5

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