Takeaway: Working capital management is just as important as revenue growth and profitability when creating value in your company as you prepare to sell it.
Most company owners will agree on this: landing a big order or project is fun, balance sheet management is anything but. That’s why company owners often leave managing receivables and payables up to the accountants. This is a mistake. When companies are growing, letting receivables run can lead to a cash crunch that can derail things. Moreover, a tremendous amount of cash (and consequently value) is locked in your working capital. Unlocking it means more free cash flow for debt repayment, reinvestment or issuing dividends. In addition, potential buyers notice companies that generate free cash flow and pay a valuation premium for these companies.
Clearly, unlocking cash is important, but how can you do it? Here are some tips.
Be Disciplined When Granting Credit
It all starts with your credit-granting policies. You wouldn’t lend money on an interest-free basis to anyone, so why allow bad credits as customers? Yet so many companies take on new customers without even checking their payment histories. The product or service your company provides delivers a specific value, for which you should be paid in a reasonable time frame. Therefore, qualifying potential customers based on their financial capabilities, payment history and reference checking just makes sense. It always feels better to turn down a bad credit than to chase after a bad credit after you’ve performed the work. Have a documented credit granting procedure as part of your standard operating procedures (SOP), and then practice it religiously to avoid costly mistakes.
Turn Work Into Invoices
The quickest way to create a cash crunch is by accumulating un-billed revenue or “work in progress.” The cash timer doesn’t even start until an invoice is generated, the customer receives the invoice and that invoice makes it into the payables system. Daily invoicing is not practical in most industries, but it is what all companies should strive for. Alternatively, aim for weekly, or every 15 days, or even every 30 days. Whatever you choose, just don’t let it go too long. If your customer only allows monthly or quarterly billing, you may want to increase the pricing for these customers to account for the carrying cost of this un-billed work, or you may not want to work for them at all. It takes courage to stop working for a customer. Keep in mind that saying “no” initially through the credit granting qualification process is an easier way to do this.
The goal of turning work into invoices is to eliminate all work in progress and, preferably, to get paid in advance. Put the money to work before you actually start spending it. It is difficult to get a valuation premium for companies that operate in industries where customers don’t allow consistent, recurring billings (like construction). If you can be a little better in those industries, the incremental valuation premium can be huge. And, of course, once you invoice your customers, be relentless in your collection efforts.
Turn Invoices Into Cash
Collections start with making the call early and often. A good process is to call your customer one week after the invoice has been issued just to ensure it was received and all supporting documentation is in place for approval. Then if the receivable goes to 30 days, follow it up with a call and offer to pick up the check if necessary. If the receivable goes to 45 days, commence the process of writing letters and becoming more assertive. If the receivable goes to 90 days, consider factoring the receivable or sending it to collections. If the customer intends to pay, it often happens as soon as they are notified that they are being sent to collections. Just don’t let this process slip.
Collections is not a pleasant process, but this is precisely why it adds value. Most companies will pay the suppliers who have a disciplined approach first. Be disciplined and your chances of unlocking cash — and consequently value — in your company will increase significantly.
Company owners don’t like to stretch payables unless they have to. Most companies pay their suppliers within 30 days, even though their customers may pay them in 60 or 70 days, extending the working capital cycle. This creates a perpetual negative cash position! While improving collections is the way to go, you can also manage payables more assertively. The key is to stretch payables without upsetting suppliers enough that they refuse to continue doing business with you. This is a fine balance, but it pays off because accounts payable is financing at zero percent interest; in other words, it’s the cheapest form of financing available.
Being consistent and transparent with your suppliers is important. If you have a policy where suppliers don’t get paid until 45 days after the invoice date, then let them know up front. If they want to price in the cost of carrying your receivables, then they can do so and you can determine if you want to use them. Most suppliers won’t take the risk.
Consider a strategy of stretching suppliers to 55 days if possible. Why 55 days? Because most off-the-shelf accounting packages show account receivables over 30 and then over 60 days. Therefore, if you pay in 55 days your account shows up as over 30 days rather than over 60 days by the time the invoice is paid. It never shows up in the over 60 category.
Working Capital and Value Creation
Cash is king. Value creation starts with revenue growth and profitability, but it doesn’t end there. You need to take that revenue and turn it into cash. Buyers always look at a company’s ability to generate free cash flow, which is significantly impacted by the changes in net working capital. Therefore, the better you are at keeping cash inflows from reducing your working capital, the more attractive your company will look.