Do your Order to Cash KPIs measure what you should manage?

This month’s article looks at why Working Capital and, most importantly, measuring related performance in meaningful & insightful ways, is essential for businesses to thrive through challenging times, and puts the spotlight on its Order to Cash leg.

by Evelyne Legaux on 14-12-2022

For much too long, businesses have been focusing on their revenue & bottom line performance while downplaying the importance of a healthy balance sheet. Post pandemic crisis however, they have no option but to consider operating liquidity, therefore Working Capital management (WCM) as a key priority going forward.

 

Why WCM is a serious matter

In essence, WCM comes down to this simple but critical question: based on what it owns – its operating assets - can a business meet its operating obligations over the next 12 months? And refers to the tools at a company’s disposal to master their operating liquidity.

To manage Working Capital effectively, business owners should ask themselves: What are my vendors’ payment terms? How long do my goods stay in stock for? How long does it take to convert my raw materials into finished products? How long do my customers take to pay me? 

 

While this may appear straightforward, the reality is much more complex as the answers to these questions typically reside with a variety of functional groups within the business organization, such as Sales, Procurement, Accounts Receivable, Accounts Payable, Supply Chain, Manufacturing, etc…. that is multiple internal stakeholders who do impact on Working Capital performance. Best is therefore for businesses to take a holistic approach to WCM and drive improvement across all areas.

 

What the above also means is that any changes to its Working Capital drive the amount of operating Cash Flow that is generated or used by a business during a given period of time.

 

And as we all know, Cash is king! Even more so in crisis times, Cash is indeed the oxygen or the fuel needed for business survival!

 

If WCM is serious, SO is measuring its performance!

At a time when the role of Finance at large is shifting to become forward-looking, agile & strategic, the insightfulness & meaningfulness of WCM performance measurement ought to follow suit, if businesses are to effectively drive improvement wherever required.

The most insightful indicator in this regard is the Cash Conversion Cycle (CCC) which measures the amount of time it takes for a business to convert a purchase of inventory (raw materials or otherwise) into Cash ultimately received from customers as a result of sales activities. In other words, the CCC measures the number of days that Cash is tied up in this operational cycle end to end.

As such, the CCC is a critical measure of a business’ health & Cash efficiency.

If Cash isn’t coming in quickly enough or else is tied up in excess inventory for instance, a  business may indeed struggle to actually settle vendors, clear social & tax obligations or even pay employees, not to mention invest in its future…

While a healthy CCC would typically depend on the industry sector combined with the geographical market for benchmarking purposes, the longer the CCC is, the more likely the business is to face liquidity issues down the line. Likewise, the more challenging the macro-economic & trading environment is, the more sensitive the CCC becomes in terms of business survival.

The actual CCC formula expressed in days: DIO + DSO – DPO nicely relates to the three legs of Working Capital, that is Inventory management, Order to Cash (O2C) & Procure to Pay (P2P).

 

So, let’s now turn the spotlight on the Order to Cash (O2C) leg of WCM…

When you have a clear understanding of what O2C is all about and the key pivotal role that the O2C Finance function plays within a typical business organization, then you also understand that it is equally vital for businesses to measure its actual performance.

Let’s focus on the word ‘actual’ for a moment.

In a world where operating Cash Flow generation is paramount for businesses, it is essential for Finance leaders & business owners to gain access to truthful insights into their O2C performance, process efficiency & policy effectiveness. Therefore, developing a simple dashboard that tracks TRULY meaningful KPIs would help support smarter business decision-making.

The reality though, is that many businesses continue to rely on ratios that, although having their own merit, do actually serve a different purpose. In doing so, they sacrifice insightfulness to speed & superficiality which end up being more detrimental than useful.

DSO is very emblematic in this regard…

Most Credit managers today continue to measure the usual suspects - standard DSO & percentage Accounts Receivable (AR) past due - to evaluate their organization’s current performance & trends.

Because standard DSO measures how fast a company turns revenue into Cash on average and is part of the statutory reporting requirements, this ratio must indeed be calculated & analysed, thus leading to many companies also using it to measure their Credit team’s performance.

As a result, Credit teams are expected to be able to explain standard DSO fluctuations over time or discrepancies vs forecast and, as such, they typically take the blame / praise when DSO goes up / down.

The truth however is inconvenient…

Standard DSO actually is a complex ratio to analyse, therefore it is often misunderstood.

In addition, standard DSO is highly influenced by a number of business drivers such as revenue seasonality or timing of sales to name a few, that are totally beyond the Credit team’s control & influence. While the cash Collections performance itself is indeed a key driver, it is only one of the factors that drive DSO up or down.

Therefore, the use of standard DSO as a KPI to assess a Credit team’s performance is both significantly biased & misleading.

To overcome this hurdle, companies have two options:

• Either measure the respective effectiveness of each one of the various functional groups that do influence standard DSO,
• Or move past standard DSO & develop a set of KPIs that truthfully measure how the Credit team is doing & trending.

If Finance at large - and its O2C component in particular - is to become more strategic, option 2 is definitely the way to go!

Finance ought to brainstorm, design & develop KPIs that not only provide meaningful insights into a Credit team’s actual performance, but equally empower that same team to help drive the business towards where it should be going, that is towards achieving the right sales with the right customers at the right time…

 

To genuinely manage O2C performance, it must be truthfully & insightfully measured!

To achieve that, companies should build on their own creativity as there are no academic limitations to what can or should be measured. It’s up to each one to determine what sort of KPIs are meaningful to their business, depending on the industry sector, market practices, types of clients, business priorities etc…

So, the sky is the limit here and, with digital technology now widely available, this is becoming a fast & painless business-led exercise.

What is important though is to ensure that the selected set of KPIs does have the level of granularity needed to measure the efficiency & effectiveness of the O2C Finance function towards fulfilling its purpose across all key areas. Doing so is even more compelling when teams are working remotely. For instance,

. how effective is your Credit policy at supporting business growth while minimizing bad debt losses?

. how effective is your cash Collections process in terms of payment timeliness?

. how efficient is your cash Applications process at automatically matching paid invoices, and how long does it take?

. how efficient is your Dispute management process in terms of turnaround time needed to close a case?

Credit decisions, cash Collections performance & cash Applications efficiency along with other activities all impact a company's CCC in many ways. Decision timeliness & accuracy affect the sales & Cash forecasts, inventory turns, the need for borrowing as well as customer satisfaction.

It is therefore a matter for each company to determine which performance metrics or KPIs will provide the meaningfulness & insightfulness required to help them monitor/drive the actual performance of their Credit policy, O2C processes & team in the best interest of the business.

Doing so demonstrates strategic leadership.

Cherry on the cake, measuring the right KPIs will also enable them to benchmark results with similar companies or individual team members with their peers.

 

Do let us know about your thoughts or questions either in the Comment box below, by email on info@financeotcconsulting.com or indeed through our Contact page.