Most business owners understand how sales on account, prompt payments and large inventory can cut into cash flow and increase working capital requirements.
It's not uncommon to see a lot of advice on how to manage receivables, payables and inventory. But too often we forget that policies affecting cash flow are also quite often related to overall business strategy. Streamlining cash flow can sometimes work against effective business strategy.
Your Strategy Dictates Sales on Account and Cash Flow
A standard business-to-business practice is to sell to businesses on account, meaning that we deliver an invoice and we wait to get paid. We deliver the goods (or service), our bookkeeping records the amount as a sale and our Accounts Receivable go up. But we don't get the actual money involved until later, when our business client pays that invoice. Normal business customers wait 45 to 60 days to pay.
For example, if you sell about $100,000 per month to business customers, waiting 60 days to get paid means you need $200,000 more in working capital than if you were always paid in cash. Each month of average waiting time could be another $100,000 you need to finance.
In theory, all businesses want to get paid sooner. Reminding customers to pay their bills can be seen as good business. But in fact, some business strategies require living with Accounts Receivable and waiting to get paid. The extra working capital requirement is sometimes seen as a cost of doing business: Find extra financing and learn to live with it.
For example, I know from experience that a manufacturer selling physical products through major distributors may have to wait four to six months for those distributors to pay. The major distributors who sell to retail chains may expect to keep your money for months (they often do that to live on very small margins). If you complain, they may sell your competitors' products instead.
Consider how much sales on account is standard practice in your industry. You may want to find out what your competition is doing. Consider branding and differentiation that accentuates your high level of value by demanding up front payments more rigorously than the others. In some cases this can send a marketing message of high quality, confidence and success. In other cases, customers or clients may turn to other vendors instead. But this may help you whittle down your customer base to those who are good for your business.
Does Your Strategy Assume Prompt Payments?
Making payments is the exact opposite of the getting paid. Sure, there is peace of mind to be gained by paying all your bills promptly. It can even be a source of pride. But paying too soon may absorb working capital too.
How long can you wait? Most invoices specify bills to be paid in 30 days, and many offer a standard 2 percent discount for payment within 10 days. But many businesses routinely wait 30, 45, 60 days or more. The accounts payable manager at a large computer manufacturing company told me once that her job was to not pay any invoice before 60 days as a part of that company's financing strategy. Waiting to pay their bills added to working capital.
Does your strategy require strong relationships with key vendors? Do you have to buy customized goods that take extra effort from your vendors? Then maybe waiting to pay is not the best strategy. But if that's not the case, then you may want to reconsider paying every bill the day it comes. While it may make some people sleep better at night, it may also hurt cash flow. Waiting too long may lead to a bad business relationship, extra hassles and late fees. But waiting 45 to 60 days is pretty standard. If you don't have to pay early, you don't have to.
Do You Keep Too Much Inventory on Hand?
Inventory on hand is another common cash-flow issue. Of course you want to give customers instant satisfaction by having that special part available exactly when they ask for it. But it can also be hard on cash flow to have a lot of inventory on hand.
I understand there's a strategy trade-off to having large inventory: It can lead to customer satisfaction, and it can be a branding advantage and differentiator. But it can also cost you cash flow: Inventory on hand is generally inventory that's been paid for ahead of time, but gets sold later.
Consider your inventory strategy. Is this part of your branding and differentiation? Do customers expect it and do business with you because of it? Do you get extra sales from the customer loyalty related to having a large inventory? Is the extra business worth the extra carrying costs?
If you answer yes to these questions, then consider the inventory drag on cash flow a reasonable cost of doing business and executing on your strategy. If not, do some sales analysis to see what part of inventory can be streamlined with special order policies instead of inventory on hand.
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