Can you uncover a company’s optimal working capital requirements – its SETPOINT – by benchmarking its peer group’s performance?
First, why should we talk about Working Capital? Great question – first of all, working capital plays an instrumental role in cash conversion, and cash should always be on management’s agenda. Second, we believe working capital ratios reflect the DNA of a company, providing vital insights into its health, agility, and growth potential.
Be that as it may, we often find companies struggling to understand their working capital requirements – their Setpoint – let alone forecast what it should look like in the future. Despite being one of the larger capital investments many organizations have to make, working capital often lacks a clear strategy and approach, with insufficient accountability and control across the organization (unlike other larger cash-out items, such as Capex and cost). In our experience, this is because true cost of working capital is much harder to gauge compared to other P&L or Balance Sheet items, and thus not always defined or implemented as part of decision-making processes.
How do you uncover a company’s working capital Setpoint? There is no short answer for this. However, a question that keeps surfacing is whether benchmarking would provide valuable insights to the process, so let us spend a few minutes on this: can we learn about a company’s Setpoint by looking at its peer group’s performance? The short answer is… no. In our experience when it comes to Setpoint discussions, benchmarking often creates more questions than answers, as:
A Setpoint is company specific – a working capital Setpoint denotes an optimal position a specific company should sustain given its current conditions and constraints;
It is not easy finding relevant peers – in order to make a relevant comparison you would have to find a company with almost identical supply chain set-up, including product, customer, and regional mix;
Published financial data is too high level to provide relevant basis for comparison – even in cases when you would find a relevant peer, published P/L and Balance Sheet information does not provide the granularity required for precise comparison. The challenges with benchmarking using published data are made further apparent when looking at statistical analysis of the Cash Conversion Cycle within selected industries and its sub-sectors (see figure 1 and 2).
Figure 1. Cash Conversion Cycle by Industry group (days)
Figure 2. Cash Conversion Cycle by industry subsector – Manufacturing and Assembly (days)
Source: NA Analysis – sample of 160 Nordic companies with annual turnover >5bn SEK, 2019 reported numbers
The variability within each industry group and its sub-sectors is striking. It is also too large to be caused by efficiency alone but is rather explained by structural differences. This makes it hard – if not impossible – to know what would be a relevant comparison, as each company’s performance is based on its individual prerequisites and limitations. Also, before you ask if we could possibly learn anything from the data averages, consider the statistician who drowned while crossing a river that he calculated was, on average, three feet deep (as wittingly stated by Sam Savage in HBR article: The Flaw of Averages, 2002).
With that said, we are not telling you to stop all benchmarking. Properly applied, you can still derive some useful information, as long as you understand and respect its limitations. It is well suited to pick up market trends, as well as triggering useful discussions, e.g., what are they doing differently?
So, what is the long answer? There are no shortcuts to understanding or achieving your working capital steady state, which is why we have approached this question through a series of articles. However, any company in pursuit of its Setpoint would do well in considering the following points:
1. Be fact based and data driven – the answer is, as so often, in the details. Track and understand your transactional data, and make sure your Item Master data files and planning parameters are accurate and up to date. Quality information is the backbone in any supply chain organization.
2. Start by being the best YOU can be – before looking at anyone else, understand your own processes and lead-times: your abilities and constraints. There is no point striving for something you cannot achieve. More often than not there are plenty incremental improvements to be done before it is time to look for structural change.
3. Maintain an end-to-end process focus – align your stakeholders across the organization, and always keep your end-customer in mind. Avoid local sub-optimization due to unresolved supply chain biases and/or conflicting interests. Remember – a company is never better than the sum of its functions.
Did you find this interesting and want to learn more? You can find all our insights on www.nordstromadvisory.se/our-insights.se