Financial Measures in Supply Chain Finance

The Example of Operating Cash Flow and Return on Capital Employed

Introduction

In our previous CRX article we mentioned how a Reverse Factoring program can have an impact on Key Performance Indicators (KPI). In this article, we would like to put two prominent KPIs into the spotlight. The article provides a brief explanation and interpretation as well as a mathematical example for each to better understand them and the role, they play in improving working capital.

What Drives Organizations to Implement a Supply Chain Finance Program?

It is a combination of strategic motivations, that drive the decision to implement a Supply Chain Finance solution. One frequently sought-after target is the stabilization of the entire supply chain, which in turn, provides significant improvement in delivery performance between all parties involved. From a Corporate Treasury perspective, however, the main target is most often an improvement in working capital, which can be achieved through the implementation of a Reverse Factoring program (otherwise known as Supply Chain Finance program) or Receivables Finance program.

How to Determine a Successful Reverse Factoring / Receivables Finance Program?

The success of these financial instruments can be determined through both, the improvement in working capital ratios as well as related KPIs. Two of the most known indicators are the Operating Cash Flow (OCF) and Return on Capital Employed (ROCE). They are good indicators for how a Reverse Factoring program or Receivables Finance program can impact the overall health of a business.

In general, KPI figures are one way to quickly evaluate company performance and as a result, often come under scrutiny by all types of stakeholders, in both small-medium and large international companies. Commonly used KPIs are therefore often leveraged and deleveraged where appropriate using a Reverse Factoring or Receivables solution.

The Effects on the Operating Cash Flow and the Return on Capital Employed

In this article, we will highlight how significant the effects of a Receivables Finance program and/or Reverse Factoring program can be on the Return on Capital Employed as well as the Operating Cash Flow.

What is the Operating Cash Flow?

The Operating Cash Flow is one of the most frequently used KPIs for controlling a company’s operating business. This measure can be found in the statement of cash flows. The statement of cash flows typically breaks out a company’s cash sources and separates them into three categories: cash flows from operations, cash flows from investing activities, and cash flows from financing activities. Here, the focus lies on the Operating Cash Flow, which is calculated either using the direct or indirect method. As this article is aiming at the explanation of the Supply Chain Finance effect and since the Operating Cash Flow is in most cases publicly accessible, we will resign on the derivation of these methods.

Operating Cash Flow: Interpretation

The Operating Cash Flow is a measure for the cash generated or utilized by a company in a defined period solely related to core operations. This measure is not equal to net income, which includes transactions that did not involve actual money transfers (depreciation is a common example of a non-cash expense, that is part of net income but not Operating Cash Flow). To calculate the Operating Cash Flow, start with the net income, which can be found at the bottom of the profit and loss, abate back and add all non-cash figures. In a next step, changes in working capital will be included to attain to the total cash generated or spent in the period.

Operating Cash Flow: Equation

short

Operating Cash Flow = Net Income + Non Cash Expenses – Increase in Working Capital

long

Operating Cash Flow
= Net Income + Depreciation/Amortization

+ Stock Based Compensation + Deferred Tax + Other Non Cash Figures
Increase in Trade Receivables Increase in Inventory
+ Increase in Trade Payables + Increase in Accrued Expenses
+ Increase in Deferred Revenue

Annotation for the Calculation of the Operating Cash Flow and Its Components From a Pragmatical Point of View​

Any non-cash figures will be returned to the measure:

  • Depreciation/Amortization, as this accounting figure reduces your net income in the P&L
  • Stock-based compensation equals the issuance of shares instead of real cash pay-out
  • Deferred taxes, as this figure considers potential taxes, that will accrue in the future
  • Other non-cash figures must  be added to the Operating Cash Flow as well, as they are not equivalent to real cash 

Changes in working capital will adjust the measure:

  • Increase in trade receivables is equal to a decrease of cash, as a share of the revenues have not been paid back by the customers
  • Increase in inventory results in a reduction of cash
  • Increase in trade payables stands for an increase in cash, as real expenses to suppliers have been prolongated
  • Increase in accrued expenses increases cash
  • Increase in deferred revenue is an increase in cash
Financial Adjustment From a Mathematical / Economical Point of View:​

As the third factor of the equation already points out the role and importance of Reverse Factoring and Receivables Finance, one can assume the power of these instruments. Hence possible configurations can be applied adequately. In theory, following options can be executed:

  1. By decreasing the trade receivables figure, the current assets are reduced, thus for example the increased excess cash can be used to pay back the vendors. Mentioned reaction leads to a plus in the working capital figure and vice versa.
  2. By increasing the value of trade payables, the current liabilities are raised, hence the cash remains longer in the company. This reaction similarly leads to an enhancement in the working capital as well and vice versa.
Preamble for the Following Examples:

Now, trade receivables will be reduced whereas trade payables will be directly or indirectly increased through the implementation of a Receivables Finance program respectively a Reverse Factoring program with the assumption of all other factors ceteris paribus remain the same. The underlying assumption of this sensitivity is the extension of the payment terms, which leads to a potential plus in the liabilities figure. These assumptions will be in force for the following KPI, the Return on Capital employed as well. The following changes of the two discussed balance sheets figures are randomly selected to emphasize the power of these programs and to explain the potential improvements explicitly. Please notice, that the effect of a Supply Chain program is the extension of the payment terms, agreed between a buyer and its suppliers by simultaneously improving the relationship between these two partners. In the following example both relevant figures are market in red.

Example:

Actual OCF (2018)3,943 + 14,921 + 5,480 + 263 – 380 – 38 – 4,658 – 6,222 + 9,328 + 368 + 959 = 23,964

Potential OCF = 3,943 + 14,921 + 5,480 + 263 – 380 – 38 – 4,658 – 4,922 + 11,128 – 368 + 959 = 27,064

Consolidated Statements of Cash Flows (EUR)
Financial_Measures_Consolidated_Stat_CF

What is the Return on Capital Employed?

This KPI is subsumed under the family of profitability measures. It tells your company and its stakeholders the result of the employed capital, meaning how profit-making is your investment. The numerator is always a measure of profit, whereas the denominator stables on the long-term capital.

Return on Capital Employed: Interpretation

The following interpretation can be reasoned: For every €1 in employed capital the company earns X% in the measure of profit in other words, profit per employed capital. In most cases the numerator is a measure of profit before interests and taxes. This is the so-called EBIT, which stands as proxy for the operating profit of a company. Ultimately this profitability KPI measures the efficiency of the company`s capital exposure.

Return on Capital Employed: Equation

Financial Measures_ROCE

With:

Employed Capital = Total Capital Employed – Current Liabilities – Liquid Funds

This KPI can be quickly calculated by using the information, which is published on the company`s profit and loss statement and balance sheet. Please note, that only the non-interest-bearing liabilities shall be used in this equation. In terms of Supply Chain Finance this is the basis for bridging the gap between the ROCE and trade payables. Of course, there can be interest-bearing trade payables contractually agreed, but this would be an exception.

Financial Adjustment:

There are two options for leveraging this KPI:

  1. By increasing the trade payables figure, the current liabilities value will be increased. This turns out in a decreased minuend. Ultimately the whole normalized quotient results in a higher value. In other words, the ROCE will be improved.
  2. By decreasing the trade payables figure, the current liabilities value will be decreased. Opposite reaction of the calculation operation finally results in a lower value. The ROCE will be decreased.
Example:
Financial Measures_ROCE2

Based on the above made assumptions, the current liabilities (tagged in red) will be increased through the implementation of a Supply Chain Finance program (in combination with extended payment terms) with the addition of all other factors ceteris paribus remain the same:

Profit and Loss (EUR)
Financial_Measures_Profit_Loss
Balance Sheet (EUR)
Financial_Measures_Consolidated_Balance_Sheet

Conclusion

Facing these two KPIs, the operating business can achieve a completely new level of flexibility and scalability. It allows the corporate to increase the profitability measures like the above presented Return on Capital Employed. However, there are still a lot more KPIs, which hold great potential to significantly influence Supply Chain Finance, which have not been mentioned in this article.