14 Jan Get more juice from the squeeze!
Need to raise funding? Look inside Your business first to turn tied-up capital into cash.
Particularly during challenging economic times, businesses simply cannot afford to be complacent and careless with working capital management. The old accounting adage is very relevant in the current environment – turnover is vanity, profit is sanity but cash is king.
If you think that you may have too much capital tied up in receivables and inventory, then please read further. Making a couple of tweaks to your working capital practices and policies could indeed help you turn that tied-up capital into cash, which could even prevent the need to raise outside funding at all.
Working capital metrics shouldn’t necessarily be benchmarked
It is fairly common for a management team to compare the company’s key performance indicators with that of other industry participants. However, industry norms and benchmarks shouldn’t be the only goal post, particularly when it comes to managing levels of debtors, creditors and inventory. Within your operating environment, you have unique circumstances, processes, customers, suppliers and products and/or services. Having an intimate understanding of how those different elements affect each other will equip you with the ability to ‘get more juice from the squeeze’. Working capital practices should be guided by the willingness to explore beyond industry benchmarks. One can secure a competitive advantage by improving one’s supply chain management and collection practices in order to reduce the working capital drag on the company’s free cash.
Don’t let bankers run the show
Credit committees at banks like using ratios. The creditworthiness of a potential client is often assessed by using current or quick ratios – indicators of liquidity. Although useful, companies shouldn’t be managed by placing disproportionate emphasis on debt covenant ratios, because doing so may result in increasing the likelihood of a liquidity crunch. Bankers prefer a higher current ratio because it provides them with comfort around managing their risk. The irony is that a high level of current assets isn’t necessarily a good thing. It enhances the current ratio from a banker’s perspective, but it can be counterproductive when trying to manage working capital more efficiently. The key is not to manage according to the expectations of bankers, but rather to manage to ensure good quality earnings and actual cash flow generation.
Customers aren’t suppliers, and vice versa
There are many companies that peg the credit terms that they receive from their suppliers to the credit terms that they give their customers. These vastly different relationships need to be managed according to the respective objectives, reciprocal value propositions, relative bargaining power, the nature of competition, industry structure, long-term outlook and opportunity costs. Ultimately, it is these factors that will determine what you can and can’t expect from customers and suppliers alike. Unfortunately, there can be a mismatch in bargaining power. For example, if a significant supplier reduces its terms, it typically doesn’t translate into the ability to reduce terms for loyal customers to plug the gap, particularly in a competitive environment. Managers should proactively shorten the collection period (with customers that are able and willing) before they are forced to do so. Good working capital management is a constant and critical function within a business and it should be monitored at all times to ensure maximum value creation.
Quantity over quality
Employee incentives can also wreak havoc on the best intentions to properly manage working capital. For example, the overemphasis of quality in production by production people can slow down production, thereby locking up capital in inventory. This makes sense because production people naturally want to reduce product defects as much as possible if their bonuses are tied to reductions in defects every year. However, the ability to charge higher prices to customers based on supposedly higher quality is actually limited to the customer’s perception thereof. Then it becomes a question of what is more costly? Slightly lower price points or much longer manufacturing cycles that lead to increasing levels of inventory? Capital that is unnecessarily tied up in inventory is exceptionally costly. Simply tightening up production cycles, and sacrifice some imperceptible quality in the process. This will most likely free up cash and therefore significantly improve the return on invested capital.
The cost of growth
Salespeople are incentivised by the sales / revenue that they generate. More sales equals better bonuses. This can have some negative and unintended consequences. Salespeople will push their customers to deliver a valid invoice and therefore book the sale, but that doesn’t mean that they will chase down late payments. In fact, in their efforts to generate revenue at all costs and also ensure future sales, they are willing to grant customers longer-than-usual payment terms and pressure procurement people into holding higher levels of inventory. This ties up cash and puts unnecessary pressure on the business.
Sales staff typically manage the relationships with customers. There should therefore be a culture within the business of knowing your customer intimately. This not only allows you to institute a more aggressive policy on debtors, but it also means you can identify financial distress within customers before it poses a problem to your own cash flow.
Employees that are responsible for generating sales should be made acutely aware of how the end-to-end sales process affects cash flow. There is a lot more to sales than simply closing the deal. When people are incentivised holistically, the ability to extract more cash (quickly) out of sales is truly enhanced.
Income statement and balance sheet incentives
The dynamic link between revenue, expenses, debtors, inventory and creditors should be well understood by people across different layers of the company’s operations. As an example, if you successfully get salespeople to call customers regularly to remind them when their payments are due, you encourage a culture of on-time payment, thereby reducing debtors’ days and putting cash in the bank. The reality of a competitive environment is that some customers may jump ship, resulting in marginal sales decline. However, this is the trade-off that needs to be considered for the benefit of long-term sustainability. In this instance, the reduction in debtors would most probably outweigh the loss in revenue from demanding on-time payment.
It is never a good idea to generate most of your revenue from one or two customers as it poses liquidity risk. Put differently, if you have a few customers that generate 80% of revenue, there is far too much concentration risk within the business. If any one of those customers experiences financial distress, the negative impact on the company as a result of late payment can be significant. The correct way to mitigate this risk is to ensure that you have good relationships with a diverse group of several customers so that if one of them stumbles, it doesn’t cause your business to trip.