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Making sure your working capital is working for you.

“Cash is king.”

This is a popular phrase in the financial world. The premise of the saying was founded in the rationale that in times of uncertainty, the liquidity of an entity is the best gauge of its sustainability.

This saying is even truer for small and mid-size businesses in India. Unlike in certain other countries, where financing may be relatively easily available at reasonable interest rates, mid-size businesses looking for funding in India face an uphill battle with onerous approval processes and prohibitively high interest rates.

For these businesses maintaining a healthy level of liquidity is not just good practice, it is critical for survival. As these companies look to expand into new product lines, customer segments, or geographies; hire new talent; make technological investments; acquire smaller businesses; or even return profits to their shareholders – cash is the ultimate emperor, without which, the kingdom is doomed.

Companies in this segment are keenly aware of the importance of liquidity, and may spend a lot of time and effort curtailing their operating expenses. All good to do, but often they are missing out on a significant source of cash that is – quite literally – beneath their noses.

Recently, I was meeting with the owner of a company that had grown his business to $10 million in revenues over the past four years and was working on an expansion strategy to ratchet it to the next league. His biggest concern was ensuring that he did not run out of fuel (liquidity) as the growth engines of the company powered into new locations. Given the burn rate of the business, it would go through its current funding in eight months, and the owner was rightfully concerned about future sustainability.

He was running a tight ship on operating costs and spoke to me about his challenge in crimping costs further at a time when the business required the investment to grow – a challenge most entrepreneurs will find eerily familiar.

Fair enough, I said. I asked him about his working capital situation. What was the status with the receivables?

He thought for a minute. Some customers did owe money and he had someone from the finance team following up with them on a periodic basis. There were billing policies in general, but given the growth mode and laser focus on revenue, sales representatives had the ability to override them. If there was a promise of a larger sale in the future, the salesperson might offer discounts or even extend the payment terms. He was also aware, through conversations in passing, that due to minor billing errors (wrong SKU mentioned on an invoice, incorrect address) some invoices were returned, thereby further delaying payment. As he spoke about the processes or lack thereof, in billing and payment, it was fairly clear to me that the business was providing free financing to many of its customers.

Let’s talk about the other side of the ledger, I told him. How timely are you in making payments to your suppliers? “Well,” he said smugly, “you won’t be able to fault us much on this one. We try to pay on the absolute last day that we possibly can without being hit with late penalties.” That’s good, I told him, but had he considered other structures, such as negotiating with suppliers to pay them sooner in exchange for discounts, or more favorable service level agreements? Did they combine orders across locations or months to take advantage of volume rebates? Had they compared the cost of capital of paying later versus the benefit of discounts that they could receive through those negotiations? They hadn’t.

Moving on, I asked him about their inventory practices. The prospect of losing sales due to stock-outs was anathema to this growing business. As a result, they were over-investing in inventory to ensure that they had a “healthy cushion” across SKUs. He acknowledged that obsolescence of inventory was an undesired consequence of this practice.

A few more questions on overall cash management policies and it was clear that at least two months of liquidity was tied up on the balance sheet. Two months of additional funding – which could make all the difference in the execution of their strategic plan and the eventual success of the business.

I leaned forward and asked him the most important question. “How regularly do you and other members of the management team receive and study a dashboard that shows the various working capital metrics – e.g., days receivable, ageing of receivables, days payable, inventory days, inventory ageing, cash conversion cycle?”

As businesses chase growth, it is easy to ignore the nitty-gritty of working capital management and devote more of your attention to other strategic and operational aspects. Disciplined cash management isn’t perceived to be as exciting as expanding into new geographies, developing a new technology or securing new customers, but it is crucial and just as important from an economic standpoint for any business.

Consider the example of a company with $10 million in annual revenues and an EBITDA margin of 10%. If its days receivable (number of days an invoice is outstanding) is 90, that implies that $2.5 million of liquidity is stuck in the receivables line of the balance sheet at any given time. With a cost of capital of 15%, the cost of carrying this on the books is $375,000 or the equivalent of four and a half months of EBITDA. If the company could bring down its days receivable to 60, that could save the equivalent of one and a half months of EBITDA. For most businesses, being able to eke out an additional month and a half of EBITDA margin would be a game changer and worth investing resources.

Releasing this capital on the balance sheet starts with having a robust system in place, which is followed by all functions. Supply chain, purchasing, sales, marketing and finance teams need to work cohesively to develop a system and processes that work both for the customer as well as the business.

At SeaLink Capital Partners we believe that having a blue print for working capital management is important. Some aspects that we emphasize companies should keep in mind include:

  1. Adopt an effective and centralized accounts payable and receivables system in order to process and issue invoices on a timely basis and reduce errors. Invest in the human capital resources that you need for a well-functioning and efficient department. Ensure that there is a robust master database that reduces clerical errors.
  2. Leverage technology to shorten cash conversion time (e.g., deliver invoices electronically). In the case of one company, we discovered that invoices were not issued for days after delivery of the service due to systematic manual documentation delays. The company was losing days of liquidity before the sale was even registered on its accounts!
  3. Establish policies and ensure that those are followed. How soon do you bill customers; is there a discount policy in place; within how many days do customers have to pay? There may be instances where policies are overridden, but those should be the exception rather than the norm. Even in those instances, there should be an approval process in place for an override of policy.
  4. Negotiate, negotiate, negotiate. Negotiate with vendors to get favorable payment terms and rebates. Negotiate with customers to establish shorter payment cycles.
  5. Ensure strong inventory control. With inventory, businesses have to walk a fine line between not carrying too much on the books and also ensuring that consumer demand can be satisfied. Finding that balance can be hard, and even large, established companies struggle with that. In 2013, Walmart lost $3 billion in sales due to out-of-stock merchandise at the same time that its inventory grew at a faster pace than sales. A robust system, which monitors demand patterns, maintains an accurate inventory count and manages the supply chain effectively is needed to ensure the optimal inventory level without compromising on customer service. Ensure that you regularly run a SKU rationalization program to purge out slow-moving stock.
  6. Have a hawk-like approach to cash-management. Create a dashboard which highlights key metrics such as days sales outstanding, days payables outstanding, inventory days, in addition to capital expenditures, debt repayments, and other cash flow items to ensure awareness at the senior management level on the cash requirements. Consider tying incentives to cash flow management metrics.

You don’t need to be a Shylock and extract a pound of flesh along with your capital, but without discipline in the cash management processes, the wheels of your growth engine can come off rather quickly. Don’t lose sight of the capital that resides on your balance sheet and make sure that it’s working for you rather than the other way around.