Most companies use some of their cash to finance customers’ purchase of products or services. That’s the “accounts receivable” line on the balance sheet—the amount of money customers owe at a given point in time, based on the value of what they have purchased before that date.
The key ratio that measures accounts receivable, as we saw in part 5, is days sales outstanding, or DSO—that is, the average number of days it takes to collect on these receivables. The longer a company’s DSO, the more working capital is required to run the business. Customers have more of the company’s cash in the form of products or services not yet paid for, so that cash isn’t available to buy inventory, deliver more services, and so on. Conversely, the shorter a company’s DSO, the less working capital is required to run the business. It follows that the more people who understand DSO and work to bring it down, the more cash the company will have at its disposal.
The first step in managing DSO is to understand what it is and in which direction it has been heading. If it’s higher than it ought to be, and particularly if it’s trending upward (which it nearly always seems to be), you need to begin asking questions.
Ask your operations manager, for example, whether there are any problems with the products or services that might make customers less willing to pay their bills. Is the company selling what customers want and expect? Is there a problem with delivery? Quality problems and late deliveries often provoke late payment, just because customers are not pleased with the products they’re receiving and decide that they will take their own sweet time about payment. The people in production and shipping thus have an effect on receivables as well. In a service company, you need to be asking the same questions of the people who are out delivering the service. If service customers aren’t satisfied with what they’re getting, they too will take their time about paying.
Ask your customer-facing managers and employees—those in sales and customer service—a similar set of questions. Are our customers financially healthy? What is the standard in their industry for paying bills? Salespeople typically have the first contact with a customer, so it is up to them to flag any concerns about the customer’s financial health. Once the sale is made, customer-service reps need to pick up the ball and learn what’s going on. What’s happening at the customer’s shop? Are employees working overtime? Is the company laying people off? Meanwhile, salespeople need to work with the credit manager and customer service so that everybody understands the terms up front and will notice when a customer is late. At one company we worked with, the delivery people knew the most about customers’ situations because they were at their facilities every day. They would alert sales and accounting if there seemed to be issues cropping up in a customer’s business.
Chances are you have someone other than yourself reviewing the credit of customers and prospective customers. That person needs to ask whether the terms offered are good for the company and whether they fit the credit histories of the customers. He or she also needs to make judgments—maybe in consultation with you—about whether the company is giving credit too easily or whether it is too tough in its credit policies. There’s always a trade-off between increasing sales on the one hand and issuing credit to poorer credit risks on the other. You and your sales or credit manager need to set the precise terms you’re willing to offer. Is net thirty days satisfactory—or should you allow net sixty? You need to determine strategies such as offering discounts for early pay. For example, “2/10 net 30” means that customers get a discount of 2 percent if they pay their bill in ten days and no discount if they wait thirty days. Sometimes a 1 percent or 2 percent discount can help a struggling company collect its receivables and thereby lower its DSO—but of course, it does so by eating into profitability.
We know of a small company that has a simple, homegrown approach to the issue of giving credit to customers. The company has identified the traits it wants in its customers and has even named its ideal customer Bob. Bob’s qualities include the following:
If a new customer meets these criteria, it will get credit from this small manufacturer. Otherwise, it won’t. As a result of this policy, the company has been able to keep its DSO quite low and to grow without additional equity investment.
All these decisions greatly affect accounts receivable and thus working capital. And the fact is, they can have a huge impact. Reducing DSO even by one day can save a company a lot of money. For example, check back to the DSO calculation in chapter 22, and you can calculate that one day of sales in our sample company is just over $24,000. Reducing DSO from fifty-five days to fifty-four in this company would thus increase cash by $24,000. That’s cash that can be used for other things in the business.
Many business owners these days are focusing on inventory. They work to reduce inventory wherever possible. They are learning concepts such as lean manufacturing, just-in-time inventory management, and economic order quantity. The reason for all this attention is exactly what we’re talking about here. Managing inventory efficiently reduces working capital requirements by freeing up large amounts of cash.
The challenge for inventory management, of course, isn’t to reduce inventory to zero, which would probably leave a lot of customers unsatisfied. The challenge is to reduce it to a minimum level while still ensuring that every raw material and every part will be available when needed and that every product will be ready for sale when a customer wants it. A manufacturer needs to be constantly ordering raw materials, making things, and holding those finished products for delivery to customers. Wholesalers and retailers need to replenish their stocks regularly to avoid the dreaded stockout—an item that isn’t available when a customer wants it. Yet every item in inventory can be regarded as frozen cash, which is to say cash that the company cannot use for other purposes. Exactly how much inventory is required to satisfy customers while minimizing that frozen cash, well, that’s the million-dollar question (and the reason for all that attention being paid to inventory).
The techniques for managing inventory are beyond the scope of this book. But we do want to emphasize that many different people in your company affect inventory levels, which means that all of them can have an impact on reducing working capital requirements. For example:
Along these lines, it’s worth noting that many U.S. plants operate on a principle that eats up tremendous amounts of working capital. When business is slow, they nevertheless keep on churning out product with the goal of maintaining factory efficiency. Factory owners and plant managers focus on keeping unit costs down, often because they learned that goal early in their careers and no longer question it.
When business is good, the goal makes perfect sense: keeping unit costs down is simply a way of managing all the costs of production in an efficient manner. (This is the old approach of focusing only on the income statement, which is fine as far as it goes.) When demand is slow, however, the owner or plant manager must consider the company’s cash as well as its unit costs. A plant that continues to turn out product in these circumstances is just creating more inventory that will sit on a shelf taking up space and cash. Coming to work and reading a book might be better than building product that is not ready to be sold.
How much can a company save through astute inventory management? Look again at our sample company: cutting just one day out of the DII number—reducing it from seventy-four days to seventy-three—would increase cash by nearly $19,000. Any company with inventory can save significant amounts of money, and thereby reduce working capital requirements, just by making modest improvements in its inventory management.