My recent interactions with CFOs in manufacturing have revealed a growing willingness to embrace a new role as a strategic business partner. An increasing number of CFOs recognise that relying solely on a financial perspective is inadequate during critical decision-making periods. They are becoming more open to consulting operational managers to make decisions that truly benefit the company in the long term.
No one disputes that drastic measures are sometimes necessary. When external financiers and banks require a company to meet specific ratios in a loan covenant, it is essential to comply. These figures, such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), cash flow, and the ratio of profit to repayments, primarily serve to reassure lenders that the company can repay its debt. A CFO is well-equipped to deliver on these financial expectations.
However, drastic measures can have a long-term negative impact, particularly when cost-cutting disrupts operations. Inventory, which is a key component of working capital, is often the first target for reduction. The traditional mindset is that less working capital is always better, leading to a quick decision to reduce inventory to increase cash.
This approach is seriously flawed. Working capital is the money a company needs to meet its daily financial obligations. It is a measure of short-term liquidity, calculated by subtracting current liabilities (accounts payable, short-term loans) from current assets (accounts receivable, inventory, cash). Healthy working capital is essential for paying employees and suppliers and for restocking inventory.
Positive working capital is good, though in an industry like retail, negative working capital can indicate high operational efficiency. It is also true that excessive working capital is not good either, as it can be the result of large inventories that tie up money that cannot be used for investments and growth.
Every company needs to develop a working capital policy that is uniquely tailored to its strategy. Just as a company has a clear strategy for its fixed assets, management must also carefully consider the level of working capital that best aligns with its strategic goals. Instead of viewing working capital as a source of savings, see it as a strategic lever to create value.
For example, a company that competes on a wide product range, excellent service, and fast delivery will choose to hold higher inventory levels. This allows it to respond quickly to customer demand. The cost of this service must be reflected in the product's price to ensure a healthy margin.
In contrast, a competitor focused on low prices cannot afford to hold the same level of inventory. They will aim for low inventory and fast turnover.
These strategic decisions must also account for product characteristics, supplier constraints, and the entire supply chain. Often, a CFO is unaware of these operational bottlenecks. This highlights the need for a constant and intensive exchange of information between the finance department and operational managers.
When CFOs get involved, they often find "sacred cows" in the supply chain that no one wants to touch. For instance, manufacturing companies frequently introduce new products with optimistic sales forecasts, but they do not consider the increasing complexity and cost this adds to production and warehousing.
Operational managers can also overlook the profitability of older products. This is where a CFO can introduce a new discipline: using portfolio management to analyse the contribution of each individual product. While companies struggling to grow, may be reluctant to trim their portfolio, there is no long-term value in selling loss-making products. Very often there is a problem with the sales prices that makes it impossible to sell the product at a good margin.
I recommend using Return on Capital Employed (ROCE) when developing a company's strategy and monitoring its investments. While this metric may be less familiar to CFOs, it is widely used by investors to measure the return on their invested capital. ROCE provides an objective benchmark for evaluating processes and new initiatives, helping you compare them based on the value they create versus their costs. It enables you to make more targeted decisions, focusing on valuable products and removing underperformers from your portfolio.
This is where a Pareto analysis is invaluable. Typically, 20% of a company's products generate over 80% of its value. By focusing on strengthening these high-performers and removing the least profitable 20%, you can have an immediate and positive effect on your company's bottom line. This is an iterative process you can repeat to ensure continuous improvement.