Authored by Ravi Gilani, Founder and Managing Consultant, Goldratt India and Ira Gilani, Director, Goldratt India
This article was originally published in Outlook Business Magazine.
Few weeks ago, I had written an article explaining cash constraint and some ways for organizations to overcome it. Subsequently, several readers informed me that I had not done full justice to the article because I had not explained why organizations run into cash constraints and how to prevent them from getting there in the first place. This is my attempt to address these questions and rectify that blemish. First, let’s recapitulate some important aspects. In my previous article, I shared TOC’s five focusing steps to overcome cash constraint within 13 weeks, or one quarter.
Step 1: Identify the constraint. When is cash the constraint?
An organization has a cash constraint if and only if all the following conditions are met:
- Sufficient orders
- Sufficient equipment, manpower and other resources including space
- Right vendors are available but will not give credit any more
- Insufficient raw materials or packing materials
- Additional cash cannot be easily arranged
Simply put, an organization is facing a cash constraint when it has sufficient orders, that is, on time in full (OTIF) < 95%, enough manufacturing capacity, that is, no machine/ equipment/ resource has overall equipment effectiveness (OEE) > 85- 90%, a reasonable number of right suppliers, and yet it suffers from material shortage as vendors refuse to give any more credit.
Step 2: Decide how to exploit the constraint
We need to squeeze as much throughput as possible through effective utilization of existing cash. In cash constraint situation, organizations need to make decisions taking into account a key parameter: cash velocity. Cash velocity is defined as an increase in per unit of cash in a period of time. As an example when the totally variable cost (TVC) is 50% of sales and the time from cash outflow to cash inflow is one month, that is, a cash induction of Rs. 50 in additional material will result in a sale Rs. 100 in a month. Here, the cash velocity per month will be 100%.
Even a small increase in cash increases sales, throughput, and profit significantly. Some of the suggested means for increasing cash velocity are: reducing customer payment time, shrinking manufacturing lead-time, and reducing supplier lead-time.
Step 3: Subordinate everything else to the constraint
All functions, departments and decisions should be aligned to get the most out of the constraint. This step is often difficult to implement, as it requires changes in existing practices and policies of local optimization. For manufacturing companies, rather than purchasing large volumes and producing large batches, it is recommended to buy the minimum raw materials required for making ‘full kit’ for immediate production.
Step 4: Elevate the constraint
In most cases, exploitation and subordination are sufficient to overcome cash constraint situation. However, if required it makes sense to borrow even at a comparatively very high rate of interest, since, for a vast majority of manufacturing organizations the cash velocity per month ranges between 10% and 15%.
Step 5: Go back to Step 1; don’t let inertia be your constraint
Once the cash constraint has been overcome, identify the current constraint. Where is your constraint – is it in orders or operations? The long-term strategic application of TOC does not imply removal of one constraint after another. Rather, the objective is to choose your constraint and manage it well to ensure that cash never becomes your constraint.
In my consulting experience of more than two decades for various types of organizations – small, medium or large, I’ve observed that the senior management usually has a reasonable knowledge of profit. Of course, it’s a different matter that they all may refer to different versions of the profit the company has earned in the previous period. Some of the commonly used profit measurements are EBITDA (earnings before interest, tax, depreciation, and amortization), Cash profit, PBT (profit before tax), or PAT (profit after tax). Some of the more financial savvy managers may also have some inkling of another important financial parameter – ROCE (return on capital employed).
However, most top managements are almost totally ignorant of another very important parameter: free cash flow (FCF). In his book, Conspiracy of Fools, Kurt Eichenwald writes that in 2001, just a month before the collapse of Enron, its chairman Kenneth Lay, CEO Jeffery Skilling, and CFO Andrew Fastow did not know that Enron will run out of cash in a matter of weeks! Often, organizations are unable to assess increased cash requirement while increasing sales, or chasing market share. In some cases, small and medium enterprises (SMEs) that are dependent on just a few big customers accept unfavorable terms in a bid to increase sales, and it increases the squeeze on cash.
The table below depicts the typical cost structure for an Indian manufacturing organization and the impact of increase in sales by 10%.
Here, for net sales increase of Rs. 10 crore per month or Rs. 120 crores per year, net working capital will increase by about Rs. 30 crores immediately. Assuming no increase in fixed expenses at all, this will translate into an increased profit after tax of Rs. 28 crore at the end of the year.
This means that for the first 12 months, the organization would have less cash than the starting cash in hand. Only after the 13th month, cash in bank will start increasing. When the organization does not have enough cash to sustain increased sales, there is high probability of the organization getting into cash constraint. Here, we have neither invested any money in increasing capacity nor increased any fixed expenses. It is obvious that when we invest additional funds for increasing capacity, stress on cash will be more severe. In a vast majority of sick companies or bank NPAs (non-performing assets), there was an expansion in the previous two-three years.
In their quest for growing fast, many companies invest without comprehensively looking at cash flow for various scenarios. Business owners and decision makers need to monitor and plan cash judiciously and ensure that they have sufficient cash buffer at all times. When you have enough cash, it does not matter much. However, if you do not have cash, then nothing else matters.
When should companies go about increasing sales and take full advantage of growth opportunities? Recommendation: Before increasing sales, improve working capital turns. Only, thereafter, increase sales slowly, keeping a hawk’s eye on the cash in hand. Instead of targeting new customer segments, exploit current customers segments, solve their pains and generate more from the same segment. Improved service levels will not only boost sales, but will also provide opportunities for increasing prices and cash velocity. Eli Goldratt summed it up succinctly when he said: Focusing on everything is synonymous with not focusing on anything.
The following table shares various stages of an organization as it gets into cash constraint.
Implementation issues
I’ve often said the TOC solutions are simple, though not necessarily easy. The biggest obstacle with cash constraint is that the top management does not accept reality. There is a belief that the situation will improve if we just tighten controls to deal with this temporary situation. Owners or key decision-makers refuse to accept they have severe issues of cash. Therefore, the first step to overcoming cash constraint is to accept that it’s an unusual situation that will not go away through usual means.
It is not just finance managers, but the entire top management team that needs to get involved to create cash flow statement for next 13 weeks or one quarter and make a plan of action. There are challenges in creating this statement sometimes due to distortions in financial reporting (such as inflated or obsolete inventory being shown on books). There are also significant differences in total receivables and collectible receivables, and disagreements between accounts and sales.
The top management team needs to agree on the useable inventory in next 13 weeks. Correcting mismatch in inventory has to be a priority. Often the total inventory available at macro level is enough for few weeks but not for next few days. Some small low-items items are always missing, while cash is blocked in high value materials that were purchased in bulk. Similarly, there has to be clarity and common understanding on the total overdue receivables and due payments that can be collected.
Thereafter, modify cash flow so that closing cash is always positive – cash can never be negative! This means prioritize actions and payments based on the current cash availability. The importance of cash velocity cannot be over-emphasized in this situation. Take actions that will block cash for the least amount of time. Sometimes, it may make sense to defer purchases of raw materials and use air rather than sea shipments, though it would be more expensive. Another action could be to sell obsolete or unusable materials, even at deep discounts.
It is of utmost importance to create a sense of urgency, be transparent with employees, modify current measurements, and take corrective actions to overcome cash constraint in a short period of time. I also recommend creating a weekly dashboard for monitoring key parameters such as free cash flow, overdue payments, cash in hand and stop measuring sales, market share, and local parameters such as efficiency.
Recent Comments