In this episode of the Inside the Strategy Room podcast, associate partner Matt Stone speaks with Sean Brown, explaining effective approaches for managing working capital and highlighting the implications for CFOs. (Subscribe to the series on Apple Podcasts or GooglePlay.)
Sean Brown: From McKinsey’s Strategy and Corporate Finance Practice, I’m Sean Brown, and welcome to Inside the Strategy Room. I’m joined today by Matt Stone. Matt is an associate partner in our London office, and he is with me at our Global CFO Forum, where he’s speaking about building a cash culture across the business and how working capital is often underappreciated as a source of cash and value creation. Why don’t we start by you telling us a little bit more about what that means?
Matt Stone: Typically, companies will focus on profitability, and rightly so. At the end of the day, you really care about the financial health of the business from a profit perspective. What that means is that companies don’t spend as much time thinking about the cash-conversion cycle and thinking through how much cash is tied up unproductively in different parts of the business—things like receivables, payables, inventory. Companies are often just completely surprised by how much cash can be released from those if they put some real focus on it. Because there hasn’t been focus on this historically, it means that sometimes you can quickly see the opportunities.
Sean Brown: What do you need to do to change that culture, and what are the biggest challenges?
Matt Stone: Working capital is not something that just a CEO or CFO can change. The payables are managed by procurement; receivables are managed by the commercial teams; inventory is a combination of the operation, supply chain, and other business leaders. To be able to turn around the performance across all of those, you have to convince a number of people at all levels of the organization to change their day-to-day behaviors.
It takes the warehouse manager who typically would reorder six months of spare parts in one go to say, “You know what, that has a big cash impact on the business.” How do we actually get that person to reorder spare parts on a more just-in-time basis every few weeks or so? Convincing that person to change their day-to-day behavior is what this is all about.
From a cultural-change perspective, it’s really around, “How do I get someone’s mind-set? How do I get them to understand what the impact of their behavior is on cash? And do I give them the capabilities and the tool kit to be able to do that?” And that’s what results in a sustainable release in working capital.
Sean Brown: Tell us a little bit about sectors. Are there various sectors that do better at this than others?
Matt Stone: The retail sector, when margins are thin, typically manages this much more closely. Because if you’re trying to get your cash flows, you can’t afford to have cash tied up unproductively in working capital. But increasingly, we see this kind of discipline around working capital and the cultural transition spreading to other sectors as well. A number of advanced-industrial clients and manufacturing clients focus on the topic. You see it, of course, in commodity-exposed companies, like mining and oil and gas, especially when the price of their particular product goes down. But the lessons from this are really spreading to a number of different parts of the economy.
Sean Brown: You’ve talked about how working-capital excellence is a journey from the basics to world-class practices. Can you tell us a little bit about that journey and the steps that are involved?
Matt Stone: Because working capital is not universally well managed, typically, putting the basics in place will release the most cash. That’s everything from the discipline around how you pay your suppliers’ invoices on time—not too early, not too late, but directly on time—to things like the invoicing process on the receivables side. Are we sending the invoice to the customer exactly when they should be getting it? Those basics can release quite a lot of cash in the business.
The second horizon is around the cultural transformation. Once you’ve put in place the basics, how do you get individuals to really understand the cash impact of their day-to-day behaviors? When they do, then you’re able to unlock an additional amount of potential cash from the business as well. This is [made up of] things like getting that warehouse manager to change their reordering strategy or getting the person negotiating the next customer contract to insist on advantageous customer-payment terms. Those types of behaviors are choices people make day to day. And if they’re not making the right choice, they’re tying up cash in the business that otherwise could have gone to shareholders or other types of investment.
The next horizon is the companies at the leading edge of this topic looking at advanced analytics and other digital tools to extract additional value. A really great example of this is using machine-learning algorithms to look at invoice-collection strategy. For your overdues and receivables, instead of having one single collections process or approach, you start doing invoice-by-invoice or customer-by-customer approaches that are tailored specifically to what you know about that particular invoice or about that customer. We’ve seen this release significant amounts of cash in some businesses. It also reduces the cost of collections, so it actually has a profit-and-loss impact as well. You also see this, with regards to inventory, in terms of using digital tools and integration with your supplier systems to be able to have that just-in-time reordering and really pervasive demand-forecasting capabilities.
Sean Brown: Can you give us an example of a client that you’ve worked with and how they have approached this?
Matt Stone: We worked with a global mining major a couple of years ago around working capital. This was quite interesting because it was deeply focused on the cultural-transformational elements. This particular company took out billions in working capital, and the reason it was successful was because it was focused on the organizational-transformation element. Right from the top, the CEO was communicating to the organization around the importance of working capital and explaining to people how their behaviors on a day-to-day basis were impacting the cash-flow profile of the company.
There was a focus on communications and how to celebrate success across the organization. The organization let a thousand flowers bloom, in terms of new ideas. And once you see some of those be successful, how do you then show others the advantages and the lessons from those to adopt elsewhere in the business?
Last, there was a big push on capabilities and giving people the tools, the knowledge, and the understanding to be able to make a change in their day-to-day behaviors. For this particular organization, it was a revolution over a 12- to 18-month period to go from a relatively unclear understanding of working capital and how to manage it to a company that was basically managing it at the minimum threshold of what they should have on their balance sheet.
Sean Brown: You mentioned machine learning previously. Are there other ways companies are using machine learning to free up working capital?
Matt Stone: What’s really interesting right now is how machine learning is being used in inventory management. The really cutting-edge companies have real-time visibility on inventories at every stage in the value chain. Once you have that visibility, and you also have a number of metrics and data points around demand forecasts and your production process, you can really start optimizing in real time the amount of safety stock you should be holding at every stage in the value chain.
This is very cutting edge for a number of companies. It’s certainly not spread widely across the economy. The idea is that you don’t just make a one-time choice around how much safety stock you should have in your production process, but you’re making a real-time optimization choice at every stage in the process, and you’re able to manage that inventory in such a way that it’s optimized through no other effort than through the machine-learning algorithm.
Sean Brown: Finally, Matt, what does this mean for the CFO?
Matt Stone: I think for a CFO, this is an important topic on two dimensions. The first dimension, and probably the most important dimension, is the value creation and potential. This is generally undermanaged in most organizations. And if it has been looked at, it’s looked at for a bit of time, and then it’s forgotten about—and things tend to go the wrong way at that point. This is a chance to sustainably reduce the invested-capital requirement of the company and also release cash and generate cash flow from the release of working capital. There is a real value-creation imperative that comes out of a topic like this, especially if you’ve looked at costs a lot and it’s time to find other levers to get additional value from the business.
The second reason this is quite important is because many CFOs are technical experts in their area around corporate finance, but this is a chance to understand and to have a real influence over other parts of the business. Working capital, of course, is the end result of behaviors and activities in the commercial team—procurement and supply chain and so on. The CFO needs to bring those different parts of the organization together in order to be able to extract the most value from all of them, optimizing the value chain. It’s a step-up opportunity for CFOs to get deep into the business and work collaboratively with their colleagues on what is a challenging but also high-potential topic.
Sean Brown: Matt, thanks for taking the time with us today.