Increased uncertainty following the result of the EU referendum and the subsequent movement in both exchange rates and commodity prices has added to the pressures facing every business. Many businesses believe the biggest challenge they face in the coming 12 months will be the demand from customers for longer payment terms. How do businesses mitigate this impact?
Why is working capital management important?
A key part of evaluating working capital performance is to understand how long it takes cash to move through your business. The Cash Conversion Cycle (CCC) measures the number of days between the purchase of raw materials and inventory through to the collection of cash from your eventual product sales.
Efficient management of the CCC can be a source of competitive advantage. Those companies that are more efficient at generating cash and outperform their peers are better able to accelerate their strategic plans, including growth ambitions without the need to obtain external funding.
Growing businesses often require more cash to improve or add facilities and equipment, and fund other operating expenses. Where growth involves overseas markets or suppliers and new or differentiated product ranges this can add complexity to the management of working capital and lengthen the CCC.
Sustainable improvements in working capital
A number of businesses look at short term actions to manage working capital, including delaying payments or reducing inventory typically around financial period ends. These actions, however, are difficult to replicate regularly without impacting wider commercial relationships and therefore do not lead to sustainable improvements. How do businesses deliver sustainable change and what are the challenges?
- Senior management focus is critical. Is working capital a permanent agenda item and is there a stated objective that reducing working capital is a business priority?
- Successful improvement programmes require broad engagement across procurement, sales, inventory management and finance, as exclusively finance led initiatives often fail.
- Enhanced management information and regular performance reviews help to drive behaviour and focus. Do you include detailed cash and working capital profiles in budgeting and annual planning cycles and business/investment cases?
- Business unit and individual performance management targets are utilised across the key cash cycle phases to focus on performance improvement.
- Help commercial and procurement teams via training to understand the impact of potential changes in working capital in negotiations with suppliers and customers.
How to improve your cash conversion cycle
1. Improving receipts from customers
A simple way of looking for improvements in the debtor’s cycle is to understand the reasons why customer invoices are overdue and develop an improvement plan to look at the underlying invoicing, collection and dispute management processes. Tightening up invoicing procedures by improving the timeliness and increasing the frequency of invoice preparation is an easy first step. Clearly documenting the contractual credit term and the trigger point for raising an invoice as well as the method of invoicing (e.g. e-invoicing) will also help to speed up the process.
In addition, understanding the range of credit terms offered to customers across products and markets should identify potential opportunities to reduce or harmonise credit terms. Businesses can manage the growth of credit terms by agreeing standard terms for particular markets or products and any deviation or request for non-standard terms would require review and authorisation as part of the contract negotiation.
Segmenting and prioritising customers by size, importance or risk profile and implementing a series of proactive collection activities should help to reduce overdue invoices. This includes defining roles and responsibilities across sales, customer service and credit control to accelerate the resolution of any customer disputes.
Invoice finance arrangements may also help, including factoring and invoice discounting. Factoring in particular may accelerate customer receipts, since buyers tend to pay factoring companies more quickly than their suppliers. For suppliers looking to decrease their Days Sales Outstanding (DSO), supplier finance programmes run by their large customers are worth consideration.
“Those companies that are more efficient at generating cash and outperform their peers are better able to accelerate their strategic plans, including growth ambitions without the need to obtain external funding.”
2. Managing supplier payments
Working capital activities have concentrated on the management of payables, including supplier payment terms. Companies see benefits from leveraging and consolidating spend, extending payment terms and increasing supplier collaboration with strategies focused on stretching terms or reducing the supplier base to achieve greater leverage in contract negotiations or paying suppliers faster in return for large early settlement discounts.
As well as reviewing supplier terms, there are other activities that could increase the time taken to pay suppliers. It is important that this is managed in a way that doesn’t increase risk within the supply chain through impacting a supplier’s cash flow. Just delaying payments can be counterproductive to developing supplier relationships and pricing negotiations.
A review of contract compliance would ensure that payment terms detailed in the latest contracts are accurately captured in finance systems so payments are not made earlier than agreed terms. Determining causes for other early payments would highlight further areas to strengthen.
Invoice acceptance and payment processes are also areas that can generate additional cash flow benefits. Whilst the invoice date has been the traditional date on which the payment term starts, alternatives are the date the invoice, or the goods or service, was received. Further, where an invoice falls on a weekend or public holiday, unless the underlying contract includes significant late penalty charges, businesses have benefitted from making payment on the next business day.
Reviewing the frequency of supplier payments may also improve cash flow and process efficiency. Payment processes have been modified over recent years to include bi-weekly, weekly, fortnightly and monthly payment runs where end-of-month payment terms are utilised. As suppliers want certainty with regard to payment, being transparent about the payment term and the payment calendar is important in developing closer working relationships.
Attempting to implement payment term and payment process changes together could lead to suppliers experiencing cash flow difficulties and disrupt the supply chain. This is where supplier finance can help by increasing payment days.
A form of receivables-driven financing, initiated by the customer through their relationship bank, supplier finance has the potential to benefit all parties involved. Suppliers obtain earlier payment of their invoices and cheaper financing, while buyers can benefit from early settlement discounts or longer payment terms without adversely impacting the supplier’s cash flow.
3. Inventory management
One of the concerns about reducing inventory is the potential impact on customers and the ability to service their orders which could ultimately lead to lower sales. Therefore, inventory optimisation needs to be considered carefully and alongside analysis of customers’ and products’ contribution to sales, profit and payment performance, enabling different service levels (e.g. targets) to be set. Operating uniform service levels for all customers can lead to high inventory levels and the potential for obsolete stock. Why offer the same level of service for a customer that continually pays you late?
“Successful improvement programmes require broad engagement across procurement, sales, inventory management and finance.”
Developing relationships and working closely with clients to understand their likely demand can also lead to better inventory management. It is important that any sales forecast is at the right product level otherwise it cannot be used for determining material requirements and will lead to difficulties in purchasing and manufacturing scheduling.
Updating supplier lead times will ensure stock is received on time and minimise last minute requests for raw materials. Managing supplier performance will help to reduce any safety stock that is held due to historical concerns about a supplier’s ability to make orders on time and in full. Negotiating shorter lead times with suppliers and reducing any minimum order quantities could also reduce inventory. Smaller, more frequent deliveries can lead to lower inventory balances.
Finally, selling to new markets and customers can lead to a rapid growth in product range. A cross-functional approach to the introduction of new products can help to minimise inventory levels where the quantum and phasing of customer demand is uncertain and harder to forecast. At the same time, monitoring the volume of sales identifies when an item is becoming slow moving and could be discontinued.
At a time when focusing on working capital is becoming more important and linked to improved business performance, it is highly likely that your competitors, customers and suppliers are looking at ways to become more efficient. Given this, can you afford not to look at all your options?
While all reasonable care has been taken to ensure that the information provided is correct, no liability is accepted by Lloyds Bank for any loss or damage caused to any person relying on any statement or omission. This is for information only and should not be relied upon as offering advice for any set of circumstances. Specific advice should always be sought in each instance. The views and opinions set out in this article are those of the author, and do not reflect the views of Lloyds Bank plc nor are they endorsed by Lloyds Bank plc.