Inventory is an asset so it’s a good thing, right? What about Accounts Receivable, or overall working capital? Yes and no to all of these. “But we have great terms – we get net 60 days!” Great!… but while extended terms for Accounts Payable is a great thing for your cash, too much of a good thing (Accounts Receivable, inventory, etc..) can kill a business.
Lets look at three battle-tested methods to improve the cash position of your company:
Reduce Accounts Receivable
Accounts Receivable is money that is owed to the business for product or services sold on credit terms, such as Net 30, Net 60, 2% 10 net 30, etc.. Reducing Accounts Receivable is the quickest and easiest way to receive an injection of cash into the business.
Many businesses will sell their products on credit terms of Net 10, but are paid routinely 30 days later or sell on Net 30 and receive payments closer to 60 days. I have heard many times that “our customers would walk away if we pressure them for payment” or “the late payment pattern is normal for our industry and can’t be improved upon.” Hogwash! The payment pattern exists because your business has trained the customers to pay that way.
To get on the right track the business has to establish a firm credit policy with processes and procedures to support it. Ideally the business could separate the collections function from the sales function – this allows the salesman to be the good guy while a back-office person is the bad guy. Finally, credit decisions should not be made by salespeople and Credit & Collections should not report through the sales organization – this would be the fox guarding the hen house.
Many private companies have three months, or more, of raw material inventory on hand, two weeks in work-in-process, six weeks in finished goods. In this scenario, you bring material in and it will be seven months before you turn it into cash (3 months + two weeks + six weeks + 60 days in A/R). If the firms’ suppliers give net 30 terms, then it’s down to six months. These numbers are very common and in this situation, the company has to have the ability to finance its’ self for the six or seven month period before the company sees the cash for the product that it just brought in last month.
What does a CFO see when he looks at three months worth of raw material? He sees the $1,000,000 that it cost and the $750,000 that he will have to put into it next month to put into finished goods and the $100,000 over the following couple months to get a sale, that will lead to $2,000,000 a couple months later. It’s the CFO who has to figure out where the money is going to come from and how to fund your paycheck.
Reducing inventory squeezes cash out of the business on a dollar-for-dollar basis. There are two numbers that you will want to quantify when it comes to inventory reduction: (1) dollar value of the reduction and (2) annual carrying cost on the dollar value of the reduction.
For instance at one location I was involved with, we reduced the inventory from $17 million to $12 million over the course of a few months. What this produced was a cash infusion to the business of $5 million and another $400,000 reduction in annual carrying cost.
Reducing inventory requires that you do not bring inventory in until you need it – it is a complete waste of cash and space to bring material in during the month of February if you don’t need it until May! Many companies order product based upon an MRP/ERP system. All of the mix/max’s, reorder points, EOQ’s, lead-times, etc.. need to be reliable to achieve meaningful inventory reduction. Check out episodes of the CashFlow ABC podcast or CashFlowABC.com for more help in getting your systems dialed-in.
Increase Accounts Payable
Accounts Payable is the other side of the coin from Accounts Payable. Your Accounts Payable is your supplier’s Accounts Receivable, just as your Accounts Receivable is your customer’s Accounts Payable.
Getting extended terms from your suppliers adds to the cash balance of the company. In addition, this will have carrying costs implications just like the inventory reduction. If you have a supplier that you have net 30 terms with a supplier that you normally have a $100,000 balance with. If you get the supplier to go to net 60 terms, you wind up with the equivalent of an interest free $100,000 loan because you now have an average A/P balance of $200,000. Like a reduction of inventory, this will inject the additional $100,000 into the company’s bank account and end up with a benefit of $8,000 in reduced carrying costs on this one vendor over the course of a single year.
I’ve known people who thought it wrong to ask for extended terms, say Net 60, from a supplier, or to ask for terms at all. It is neither wrong, immoral, unethical nor unwise to ask for extended terms. Whatever terms you and your suppliers (or customers) agree to are completely acceptable as long as it’s legal.
What you will notice is conspicuously absent from the list is increasing revenue (sales) and reducing expenses. This is because those are the truly obvious ways of increasing cash flow and also the most difficult. As long as there is positive income, you have very little chance of turning a cash-lemon into a cash-cow by reducing expenses or increasing revenue. By far, your best chances are in managing your Working Capital (A/R, Inventory, and A/P).