Lower interest rates in recent years have dimmed the spotlight on the essential business function of working capital management. Many companies have chosen to take advantage of lower interest rates by borrowing against their lines of credit instead of continually improving their working capital processes and collection practices. This strategy may be workable now, but what happens when interest rates begin to rise?
According to the 2015 CFO/REL Working Capital Scorecard, only 96 companies out of the 967 surveyed have improved their Cash Conversion Cycles (CCC) over the past three years. What exactly is the CCC and why is it important to lower CCC while interest rates are low?
The Cash Conversion Cycle is a measure of overall working capital performance. The CCC takes into account:
- how quickly a company collects on receivables.
- how much inventory they keep on hand.
- the amount of time they take to pay their payables.
Companies that work to improve their working capital management by lowering their CCC will have a competitive advantage once the interest rates do rise. In other words, they will have more cash and less interest expense than their competitors.
In order to lower their CCC, companies need to focus on improving performance in these three key areas: accounts receivable, inventory and accounts payable.
Reducing accounts receivable is the obvious answer to improve cash flow without financing. If a company collects cash from their sales faster, they will have more cash to move to other areas of the business. Collecting receivables, however, is sometimes easier said than done. Many buyers attempt to defer payments as long as possible in order to retain cash. There are ways to combat this tactic and collect faster.
First and foremost, companies should establish timely billing practices. The company should send the invoice to the customer as soon as possible: the longer an account remains unpaid, the lower the probability of collecting that account. The invoice should clearly state discounts for an early payment as well as the penalty for late payments. After sending an invoice, the company should firmly enforce payment terms. If a customer is late on a payment, the customer should be charged the late fee stated on the invoice.
Another way to decrease the time it takes to receive payments is to contact the customer directly. When a customer’s payment is late, the company should call the following day. Letters and other written reminders are often times ineffective, as they only provide one-way communication. Verbal communication will reinforce the company’s collection policies.
In addition to collection policies, stricter credit policies are one more way a company can improve collection of receivables. Credit policies should be in place to ensure that companies do not sell to customers who would be unable to pay their balances on time.
In order to achieve a lower CCC, companies need to reduce their overall investment in inventory. One simple way a company can lower inventory levels is to sell older or outdated inventory at a discount. Another option would be for a company to partner with vendors to supply them with inventory on a consignment basis. A third option, companies can calculate how much inventory needs to be kept on hand in order to meet demand without holding extra inventory. Armed with the right data, companies can continue to maintain these proper inventory levels and adjust to changes in the demand without keeping excess levels of inventory.
Days Payable Outstanding (DPO) is a metric that is used to measure a company’s average payable period in days. It is calculated by taking the year-end accounts payable divided by one day of cost of goods sold. Companies can use this number to compare themselves to others in the same industry and determine if there is room for improvement. If their DPO is smaller than others in the same industry, then they may need to work on stretching that number and delaying payments.
Vendor relationships and the timing of payments can drastically affect the amount of cash available for working capital. The company should work to extend payments as much as possible and establish discounts for early payments. The company should negotiate payment terms with the vendor based on how much the vendor needs that company’s business. If it is the vendor’s largest customer and the vendor cannot afford to lose their business, the company will be able to negotiate better terms. If the company is a smaller customer, however, it may not be able to extend payments more than the industry standard.
A Proactive Approach
Companies need to be proactive with their approach to managing working capital while interest rates are lower. Those companies who work to improve now will not be as deeply impacted once interest rates do begin to rise. Instead, proactive companies will be poised for growth through these strong working capital management practices.
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