Chapter 17
How Companies Keep the Cash Flowing
In This Chapter
Slowing down bill paying
Collecting accounts receivable more quickly
Ordering less inventory
Finding quick cash
Managers sometimes face a shortage of cash to pay the bills and need to find ways to fix the problem. They can use a number of different strategies to get their hands on cash quickly when running a business.
In this chapter, we review the pros and cons of the possible fixes available when a manager finds a red flag about a company’s cash flow.
Slowing Down Bill Payments
Short on cash? Well, maybe you can just let your bills slide. It may not be the most responsible policy, but sometimes doing so can get a company through a financial rough patch – as long as its suppliers are relatively patient. Trade financing is when businesses buy on credit and don’t have to pay cash upon receipt of the goods. Often, these businesses must pay for those goods within 30, 60, or 90 days. When cash gets tight, one of the first strategies many small-business owners use – and even some large corporations – is to pay their bills more slowly and, sometimes very late, to make it through a cash crunch.
This practice is known as ‘stretching accounts payable’ or ‘living on your suppliers’. Some companies use this strategy as long as their suppliers tolerate the late payments – in other words, until their suppliers threaten non-delivery of goods. The primary advantage of this plan is that the manager or business owner doesn’t need to look for a way to borrow additional money to pay operating expenses. The big disadvantage is that companies can build bad reputations among their suppliers and are less likely to get trade financing in the future.
Paying bills early can be an even bigger advantage for companies than delaying payments for as long as possible. In Chapter 16, we talk about how much money companies can save by taking advantage of trade discounts rather than paying bills on time. Although slowing bill payment may be the easiest way to deal with a cash-flow problem, it’s the option with the least advantages and the greatest potential for hurting business operations in the long term, especially when suppliers finally decide to stop providing the goods needed.
Collecting Accounts Receivables Faster
If a company owes more money than it has, clearly, it needs to bring in more money. A business whose cash is tight often brings in more money by speeding up the collection of its accounts receivables – money owed by customers who bought on credit or people who borrowed from the company. To collect the money, a company must make changes to its credit policies. A company can make these changes to one or more of five basic variables in its credit policy:
Credit period: Companies can change the length of time they give their customers to pay for their purchases. A liberal credit period can give customers 60 or 90 days to pay, whereas a conservative credit period can allow as few as ten days.
Credit standards: In times of trouble, a company can loosen the policies it uses to determine a customer’s credit eligibility. For example, a company that requires customers to have an income level of at least £50,000 to get a £1,000 credit line may decide to allow customers to get the £1,000 credit line with an income of only £30,000. This policy change increases the credit-customer base and allows more people to buy on credit, thereby increasing sales; however, the change can also lead to more customers who’ll have difficulty paying their bills.
Collection period: Companies with strict collection policies can begin contacting slow payers or prohibiting them from making further purchases, even if their account is just a few days late. Other companies wait at least 60 days or longer before they follow up on late accounts. Shortening the credit period can get more cash in the door quickly, but this policy can also cause customers to buy fewer products or to move their business to another store or company.
Discounts: Companies can encourage their customers to pay their bills earlier by using a discount programme. We discuss using discount programmes in greater detail in Chapter 16. For example, a company can offer customers a 2 per cent discount for paying their bills within 10 days of receiving the bill, but if the customers wait 30 days to pay their bills, the company expects the payment in full. Deciding to add or change a discount programme may speed up cash collections, but also lowers the profit margin on sales because these discounts bring in less revenue.
Fees and late payments: Companies must decide whether or not they want to charge late fees or interest to customers who don’t pay on time. Companies with a strict collection process charge a late fee one day after the due date of a bill and start adding interest for each day that the payment is late. Companies with a liberal collection policy don’t charge late fees or add interest charges to late payers. For example, a company could charge a £25 late fee when a bill is paid ten days after it is due to encourage on-time payment. This strategy encourages slow payers to pay more quickly, but can also chase customers away if one of the company’s competitors doesn’t impose late fees or interest charges.
Before a company that’s trying to speed up its incoming cash flow makes any changes to its credit policy, it must look at a number of financial variables to determine the long-term impact the change may have on its sales and profit margin. Stricter accounts-receivable policies are likely to irritate customers and increase staff workload, whereas looser policies may encourage more sales but result in more bad debt that a company has to write off.
Companies must carefully assess the potential cash-inflow change and potential staff costs, as well as the impact a policy change may have on customers before they change their credit policies. Though at first glance the change may look like a good idea for improving cash flow, its long-term impact may actually reduce sales or profits. Top executives must discuss with managers in sales, marketing, accounting, and finance the potential impact the changes in credit policy may have to fully assess the possible ramifications of the change. For instance, any change in credit policy increases the staff’s workload. When a company eases its credit standards and increases the number of customers who can buy on credit, it needs more staff to manage its accounts receivable and keep track of all the new customer accounts. If a company decides to make its credit standards stricter and requires a more time-consuming credit check before establishing new customer accounts, the company has to hire more staff to do those credit checks or hire an outside contractor to do the checks. Either way, a stricter policy costs more money and may drive customers away.
Borrowing on Receivables
Rather than delving into the complicated realm of credit-policy changes (see preceding section), many companies use invoice factoring. In this type of programme, a company sells its trade receivables, which include all accounts of customers who buy on credit, to an outside party – usually a bank or other financial institution – in an arrangement called ‘factoring’ to get immediate cash for its receivables. As the receivables come in from customers, the company repays the financial institution. Most companies retain the servicing rights of the receivables, which means that they continue to collect from customers and receive servicing fees for doing that collection. Factoring companies also take over the whole sales ledger and actively collect debts.
Two standard options for selling receivables are:
Selling the receivables for less than they are worth: For example, a factoring arrangement’s terms may be that the company gets 92 pence for each pound of receivables, which, in essence, is equivalent to an 8 per cent interest rate.
Paying interest as if the company had taken out a loan secured by a physical asset, such as a building: For example, a company’s credit terms for the factoring arrangement may set up an annual interest rate of 8 per cent. But for customers who pay their bills within 30 days, the amount of interest they actually pay on the accounts receivable loan is only 1/12 of 8 per cent for the one month that they borrowed the money while waiting for a customer to pay.
In addition, companies usually have to pay upfront charges of 2–5 per cent to set up the programme.
The biggest advantage of using factoring is that a company has immediate access to cash. The biggest disadvantage is that the company ends up with less than the full value of the receivables when it collects from its customers because of discounts or any interest paid on those receivables.
Reducing Inventory
Companies in a cash-flow crunch sometimes decide to reduce their on-hand inventory. Doing so certainly reduces the amount of cash that must be laid out to pay for that inventory, but can also result in lost sales if customers come in to buy a product and don’t find it on the shelves. Then customers are more likely to go to a competitor than wait for the product to arrive.
Many companies use a just-in-time inventory process, which means the product shows up at a company’s door just before it’s needed. To set up this type of system, a company must know how many sales it normally makes over a period of time and how long it takes to get new products. Then the company calculates when it must order new products so it receives them just in time before the shelves become empty. This system reduces the inventory a company has to store in its warehouses and the cash payments it must make to suppliers for the products it purchases. When done correctly for a product that moves quickly off the shelves, the company may even sell the product and collect cash before it needs to pay the bills. This strategy certainly helps a company manage its cash flow and reduce the amount of cash it must borrow to pay for inventory.
The big disadvantage of using a just-in-time inventory system is that estimates are sometimes wrong. For example, a company decides when it needs to reorder and how much it needs to reorder based on historical sales data. If a product’s popularity increases dramatically before a company can adjust its inventory-purchasing process, store shelves may be empty for days before new products arrive – just when the public is rushing to get the product. As a result, the company loses sales to a competitor who still has the product on its shelves. Any cash that customers would have paid for those goods that were not available is cash that’s permanently lost to the company.
Other times, a just-in-time inventory system breaks down because a problem occurs in the supply chain. For example, if a customer orders a product from a company in Singapore, and a major storm shuts down the manufacturing plant for a week or more, product deliveries will be delayed. The company selling the product may be left with empty shelves because the inventory on hand ran out and the new inventory won’t show up for a few weeks until the manufacturing plant can restore its operations and begin shipping products again. The result is a lot of cash lost to the company because customers are forced to buy the goods elsewhere.
Although reducing inventory does save the company the cash upfront that it must pay to buy that inventory, inventory reduction could actually result in a loss of sales and less cash in the long run if customers have to go elsewhere to find the products they want. Inventory reduction makes sense only when the company believes the product is sitting too long on the shelves, and there isn’t enough customer interest in buying the product.
Getting Cash More Quickly
The most flexible way for a company to keep its cash moving is to have numerous options in place so it can borrow cash when needed or speed up cash receipts. Companies can choose among the following options to keep their cash flowing:
Credit cards: Credit cards can be a great way for a company to conserve cash and pay bills. Banks offer companies a range of credit cards, debit cards, and other short-term cash options to help companies maintain cash flow. Banks can put controls on these cards to ensure that a company’s employees don’t abuse them.
Lines of credit: Lines of credit allow companies to access cash as needed. The bank or financial institution sets a maximum amount of credit that the company can borrow and then gives the company cheques, or allows it to transfer cash into another current account, making it easy for the company to get cash when needed.
An unsecured line of credit: This type of credit isn’t backed by the company’s assets, which means that if the company can’t pay back the loan, the financial institution cannot seize its assets.
A secured line of credit: This type of credit is backed by the company’s assets, so the bank can foreclose and take possession of the asset that backs the line of credit if the company fails to pay back the loan.
Electronic bill payment: Many companies allow customers to pay their bills online and send in bills by e-mail to speed up the cash-collection process. When they get money from customers more quickly, companies speed up their incoming cash flow.
Merchant services: A company can get access to their customers’ money much more quickly by using electronic payment systems when accepting credit and debit cards. Nearly all stores now use electronic payment systems rather than paper copies when accepting credit cards. Rather than waiting for paper transactions to yield cash – which sometimes occurs days later – companies can use electronic payment systems that can access cash within minutes.
Loan guarantee scheme: In this arrangement the government provides a guarantee to the clearing banks that lend to small businesses. Specifically intended for medium-term finance, the scheme has a limit – currently 70 per cent of loans up to £100,000. The cost to the company is that it pays a premium for the guarantee of 1–2 per cent.
Leasing and hire purchase: Both of these methods spread out the payments for an asset. A finance charge is made for the arrangement, the equivalent of interest, and this interest can be quite high if the asset is in demand – or reasonably low when the suppliers are looking for customers. Car manufacturers, for example, give very good terms for leasing their cars when the car market is sluggish.