More than once, this blog has underlined the importance of undertaking significant changes long before the business is in crisis. Of course, this is not what generally happens in reality: all too often, organizations wait until they already have one foot in the grave before addressing systemic problems and perhaps getting competent external support.
It is never too late
The good news is that even then, all is not necessarily lost. With the right focus, even the bleakest of forecasts can frequently be turned around. This does however become a much more painful process – not because the measures that must be taken are particularly punishing, but because the organization’s entire future is at stake, making radical paradigm shifts seem all the more threatening. In times of crisis, humans tend to fall back on the familiar.
Ravi Gilani is a business consultant in India and CEO of Goldratt India. He is often called upon when businesses needs to be saved from the brink of destruction. In a very insightful article1, he describes how a clear focus on the constraint can often be enough to turn around the most desperate direst situations. The Five Focusing Steps get to prove their validity once again!
The cash constraint
„Companies do not fold up when they make losses, they shut when they run out of cash,” writes Gilani, pointing towards the constraint almost every business runs into just before its demise – when it can no longer pay its suppliers and they refuse to extend its line of credit. What’s lacking is simply solvency, in other words: cash. Once all cash reserves have been exhausted, the business must cover ongoing costs with its working capital: any money coming in will immediately be re-assigned in order to keep business going; the working capital is depleted in a non-linear manner.
If the incoming payments are too low (or too slow), then sooner or later production will work far below its full capacity (as there are insufficient funds to purchase the necessary raw materials) and bankruptcy moves ever closer. Traditionally-used saving measures have little effect in this scenario; they merely drag out the inevitable a little. So what is the determining factor in this situation? It isn’t profit or revenue, says Gilani, but cash velocity: the “increase in cash per unit of cash in one period of time.” To give a simple example: if totally variable costs are 50% of sales and the timeframe between cash outflow and cash inflow is one month, cash velocity is 100% per month: €50 turns into €100 after one month.
Exploiting the constraint requires a paradigm shift
The speed at which money flows through the system is much more important than the actual amounts: the cash-to-cash cycle must be reduced. Optimally exploiting this constraint will only work by throwing out long-held policies and behaviors, as they go directly against the exploitation (in other words, they are not subordinate to it):
- Bulk discounts from the supplier must be avoided. They may save money in the long term, but they lead to unnecessarily high inventory of raw materials and deprive the company of cash needed to purchase other essential supplies: full kit is jeopardized and manufacturing time delayed unnecessarily.
- Local optima during production are equally detrimental. It is often customary to produce larger batches than necessary in order to save setup times. This leads to precious cash reserves being tied up in unwanted end products – which now need to be stored at additional cost.
- Manufacturing lead times can also be reduced. Using concepts such as the Theory of Constraint’s Drum Buffer Rope can help achieve remarkable results.
- Another important – and often overlooked – aspect is supplier lead time. It may be worth switching suppliers if this helps reduce supply times – even if this means a slight price increase.
- And last, but not least: It is more important for customers to pay quickly than to pay the full amount. This can be achieved by offering discounts for immediate payment. This is completely counterintuitive if working from the assumption that what’s most important is how much money comes in. In fact, the opposite is true: even the smallest reduction of the cash-to-cash cycle will lead to a significant increase of cash velocity and help escape the cash constraint.
Gilani has found it particularly hard to persuade people of this last concept, which is why he often uses a case study from his past to demonstrate its validity.
A simple calculation
Let us take a manufacturer of switches with total variable costs of 40% of net sales, 3 days manufacturing lead time and 60 days realization time. In this scenario, €40 turn into €100 sales (i.e. €100 cash inflow) after a total of 63 days. In other words, €1 becomes €2.50.
If this business offers a 50% discount for immediate payment, the initial €40 will only generate €50 sales, but after merely six days (3 days manufacturing lead time and 3 days to obtain credit from a bank). €1 now turns into €1.25 after 6 days. After another 6 days it is worth 1.25×1.25 = €1.56. Continuing in this vein for the full (old) conversion time of 63 days, our initial €1 ends up generating €9.31 – nearly four times the €2.50 that would have been created the “conventional” way!
A similar calculation applies when deciding whether to get new credit. The business will likely have to accept higher interest rates based on its poor financial health, but they may still be viable – as long as they are below the cash velocity of the business (according to Gilani, this tends to be 10-30% per month, but you can easily work it out for your business).
A valuable lesson
This situation clearly shows how important it is to question existing paradigms! Traditional methods used to overcome cash constraints are often counterproductive: local measurements such as increasing sales or tonnage, reducing distribution or interest costs tend to have a negative impact on cash velocity rather than a positive one.
In his many decades of experience, Ravi Gilani has time and time again saved companies from the brink of bankruptcy and led them back to becoming profitable operations. In most cases he was able to shift the constraint after 13 weeks (or a quarter) – either into production or even into the market. Of course, the same applies here as in any other case where the Five Focusing Steps are employed: the process must start over; inertia must not become the constraint!
1: Why Cash Should Be King – How some unorthodox solutions can help corporates emerge out of life-threatening financial crises, Outlook Business 2015. http://www.outlookbusiness.com/perspective/why-cash-should-be-king-1788