The Monthly Metric: Cash Flow From Operations
The speed of change and the severity of challenges facing supply management organizations show no signs of abating, especially as a once-in-a-century pandemic remains uncontrolled.
So, it makes sense that measurements of organizational procurement and supply chain performance should be reevaluated to reflect changing priorities and tailor to company-wide goals. That is the focus of Metrics of the Future: Moving Supply Management Beyond Cost Reduction, a report released in September by CAPS Research, the Tempe, Arizona-based program in strategic partnership with Arizona State University and Institute for Supply Management® (ISM®).
This space covered an accompanying webinar and suggested that analytics detailed in the report would be the subject of future editions of The Monthly Metric. That process begins this month, appropriately, with a measurement that has increased in importance at many procurement organizations, due in part by the coronavirus (COVID-19): cash flow from operations (CFFO).
As the pandemic restricted businesses and slowed supply chains, cash flow became a critical issue for many companies — and especially suppliers, says Lisa M. Ellram, Ph.D., MBA, C.P.M., Rees Distinguished professor of supply chain management at Miami University in Oxford, Ohio. Ellram, one of the CAPS Research report’s authors, says that, unlike during the Great Recession of 2008-09, companies generally did not extend payment terms, a trend confirmed by surveys from ISM Research & Analytics.
“Many companies actually paid their suppliers faster — it was a matter of survival because their suppliers needed the cash flow more,” Ellram says. “So, it started to get attention and become a topic of conversation, and it’s continued to evolve since then. And part of that discussion is the role that procurement plays, and how much money is tied up in accounts payable to suppliers.”
While the report focuses on measuring and improving a procurement organization’s performance beyond cost savings, that remains a high priority for companies. Cash flow is the lifeblood of a business, Ellram says, and payment terms are a big driver of procurement’s contribution to it, though it’s not the only one. “It’s a metric that finance loves,” she says. “It helps get more attention on procurement and the contributions it makes. But it’s important to look at this metric in a holistic way, so the impact of supply chain financing on suppliers is considered. Because it can affect those relationships.”
Meaning of the Metric
The formula for calculating cash flow from operations can vary by company, but Ellram says there is consensus on where procurement organizations look first to increase it: by adjusting payment terms with suppliers. The most common adjustments involve (1) extension of payment terms, (2) discounts, (3) dynamic discounts, in which a supplier can opt to be paid sooner in exchange for a lower price, and (4) supply chain financing, facilitated by a bank or third party.
While adjusting payment terms can provide cash-flow rewards on a financial statement, Ellram says, there can be risk to supplier relationships. She cites a decision by Anheuser-Busch InBev in January 2009 — the heart of the Great Recession — to extend payment terms from 30 days to 120 days with little warning for suppliers. That created US$824 million in working capital for the St. Louis-based brewing and beverage behemoth, but its suppliers lost that capital, and most incurred substantial financing costs.
A global company like Anheuser-Busch InBev can risk alienating a key supplier; most smaller organizations do not have that luxury. In her research, Ellram found a company that extended payment terms but in later contracts with the supplier, was charged for services previously provided for free. “It will look good for the bottom line, but how will it affect other aspects of performance?” Ellram says. “I’ve talked to plenty of suppliers, and they’ll tell you when things get tight, they won’t always work harder for companies that (adjust payment terms). So, there can be competing issues at work.”
Inventory management is another vehicle to free up cash flow, usually through stock reductions or a consignment agreement with a supplier. Though CFFO measurements can be broken down by specific payment-terms or inventory-management process, Ellram says most companies prefer to capture all aspects of cash flow.
Synergy With Finance is Critical
Ellram says that CFFO can be a “dysfunctional” metric when the allure of increased short-term cash flow results in companies paying more in the end. “In many cases, it’s not free money,” she says. If a supplier is aware that payment terms could and will change, it will work that into the price.
This is especially prevalent, she adds, in dynamic discounting, in which a buyer pays the full invoice amount at the end of a payment term and a discounted price if the supplier opts to be paid early. “Suppliers will make an (overall price) calculation based on what makes a dynamic discount worthwhile for them,” Ellram says. “If they didn’t, they wouldn’t stay in business. I could argue that with people in finance until I’m blue in the face.”
That makes a holistic view of CFFO important, she adds, meaning that the procurement and finance departments must be aligned on cash-flow objectives. “It’s critical for procurement to be able to explain why the company should offer dynamic discounting and when it’s beneficial to pay a supplier more quickly,” Ellram says. “I’ve found that in a lot of cases, procurement extended payment terms because it was told to, and there was no discussion about the broader implications of it.”
The opportunity for supply management practitioners to influence organizational cash-flow decisions has likely never been higher, due in part to a pandemic that has raised awareness of the function’s importance at many companies.
“It’s important for procurement to work closely with finance to protect those supplier relationships, and procurement is in a good position to do that,” Ellram says. “That will improve relationships with finance and suppliers. And when finance understands that procurement is looking at cash flow in such a strategic way, that will only elevate the position of procurement in the company.”
To suggest a metric to be covered, email me at firstname.lastname@example.org.