Chapter 17

How Companies Keep the Cash Flowing

In This Chapter

Delaying bill payments to increase cash flow

Collecting accounts receivable more quickly

Using a receivables securitization program

Ordering less inventory

Finding quick cash

Managers sometimes face a shortage of cash to pay the bills, and they need to find ways to fix the problem. They can use different strategies to get their hands on cash quickly when running a business.

In this chapter, I review the pros and cons of the possible fixes available when a manager finds a red flag about a company's cash flow.

Slowing 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 fiscal rough patch — as long as its suppliers are relatively patient. When businesses buy on credit and don't have to pay cash upon receipt of the goods, this is called trade financing. Often 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 (and even some large corporations) use is to pay their bills more slowly, and sometimes even pay them late, to make it through a cash crunch.

This practice is known as stretching accounts payable or riding the trade. Some companies use this strategy as long as their suppliers and vendors tolerate the late payments — in other words, until they threaten nondelivery 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 vendors 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, I talk about how much money companies can save by taking advantage of trade discounts instead of 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 vendors and suppliers finally decide to stop providing the necessary goods.

When reading a financial report, you can test to see whether a company may be choosing a bill-paying delay strategy by calculating its accounts payable turnover ratio (see Chapter 16). If the turnover of accounts payable is slowing from one year to the next, it may be a sign that the company has a cash-flow problem.

Speeding Up Collecting Accounts Receivables

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 that customers who bought on credit or people who borrowed from the company owe. To collect the money, the company must make changes to its credit policies, focusing on one or more of these five basic variables:

• 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 10 days.
• Credit standards: In times of trouble, the 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 offer that same credit line to customers with an income of only $30,000. This policy change increases the credit-customer base and allows more people to buy on credit; however, the change can also increase the number of customers who 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 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.
• Discounts: Companies can encourage their customers to pay their bills earlier by using a discount program. I discuss using discount programs in greater detail in Chapter 16. For example, a company can offer customers a 2 percent 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 program may speed up cash collections, but it lowers the profit margin on sales because these discounts bring in less revenues.
• Fees and late payments: Companies must decide whether 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 a bill’s due date 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. To encourage on-time payment, a company could charge a $25 late fee when a bill is paid ten days after it’s due. This strategy encourages slow payers to pay more quickly, but it 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 honk off 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.

To fully assess the possible ramifications of the change, top executives must discuss with managers in the sales, marketing, accounting, and finance departments the potential impact of the changes in credit policy.

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 the company decides to make its credit standards stricter and require a more time-consuming credit check before establishing new customer accounts, it has to hire more staff or an outside vendor to do those credit checks. Either way, a stricter policy costs more money and may drive customers away.

So before they change their credit policies, 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. 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.

You can test whether a company is having problems collecting from its customers by calculating its accounts receivable turnover ratio. To find out how to calculate this ratio, turn to Chapter 16.

Borrowing on Receivables

Instead of delving into the complicated realm of credit policy changes, many companies use a receivables securitization program. In this case, I'm talking about accounts receivable, which include all accounts of customers who buy on credit. In this type of program, a company sells its receivables to an outside party — usually a bank or other financial institution — to get immediate cash, and 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 administering that collection.

Two standard options for selling receivables follow:

• Selling the receivable for less than it's worth: For example, a program's terms may dictate that the company gets 92 cents for each dollar of receivables, which, in essence, is equivalent to an 8 percent interest rate.
• Paying interest as if the company had taken out a loan secured by a physical asset, such as a building: For example, the company's credit terms for the securitization program may set up an annual interest rate of 8 percent. But for customers who pay their bills within 30 days, the amount of interest the company actually pays on the accounts receivable loan is only 1⁄12 of 8 percent for the one month it borrowed the money while waiting for a customer to pay.

In addition, companies usually have to pay upfront charges of 2 to 5 percent to set up the program.

The biggest advantage of using a receivables securitization program is that the 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.

You can find out whether a company uses a securitization program by reading the notes to the financial statements. If a company does use this type of financing, it includes in the notes information about money it has borrowed on a short-term basis, called short-term financing.

Reducing Inventory

Companies in a cash-flow crunch sometimes decide to reduce their on-hand inventory. Doing so certainly reduces the amount of cash the company must lay out to pay for that inventory, but it also can result in lost sales if customers come in to buy a product and don't find it on the shelves. Customers may then be more likely to go to a competitor than wait for the product to arrive.

Many companies use a just-in-time inventory system, 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 that it receives them just 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 and vendors for the products it purchases. When done correctly for a product that moves quickly off the shelves, the system works well — 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 and how much it needs to reorder based on historical sales data. If a product's popularity increases dramatically before the 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 weren't 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 are 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. This could result in a lot of lost cash to the company because customers would be forced to buy the goods elsewhere.

Using financial reports, you can test how quickly a company's inventory turns over by calculating the inventory turnover ratio, which I discuss in Chapter 15. However, you won't be able to tell whether the company regularly runs out of products on its shelves by reading the financial reports. You can determine that issue only by periodically stopping by stores to find out.

Although reducing inventory does save the company cash up front that it would normally pay to buy that inventory, inventory reduction can 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 customer interest in buying the product is low.

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 from 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 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 gives the company checks or allows it to transfer cash into a checking account.
  • 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 can't seize the company's 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.
• Lockbox services: Companies can set up these services with a bank so that they pay their bills directly to the bank, using a lockbox; then the bank deposits the money directly into the company's account. This method can speed up cash flow because the bank deposits the funds upon receipt, eliminating the day or longer it normally takes for checks accepted by the company to be processed in-house and then deposited in the bank. However, electronic banking and bill paying has eliminated the need for many lockbox services.
• Electronic bill payment: Many businesses 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 firm can get access to money much more quickly by using electronic payment systems when accepting credit and debit cards. Most stores now use electronic payment systems rather than paper copies when accepting credit cards. Instead of waiting for paper transactions to yield cash — which sometimes occurs days later — companies can use electronic payment systems to access cash within minutes.
• Small Business Administration loans: Small businesses can get low-interest loans guaranteed by the U.S. Small Business Administration (SBA) to assist with cash-flow problems, which helps a small business owner get approval for the needed funds.