Keeping Cash King in a Down Economy

Working capital-the money needed to fund day-to-day business operations-is a primary indicator of a company’s financial health.

A healthy cash flow enables companies to meet current and long-term financial obligations with reduced reliance on external funding. Without positive internal cash flow, many companies rely on lines of credit and short-term borrowing for day-to-day expenses, which further increases the cost of doing business. In a credit-dependent industry, such as construction, many profitable companies can find themselves in financial difficulties if they fail to manage their working capital appropriately.

Regardless of whether the U.S. economy is officially in a recession, it is clear that the economic downturn is affecting the credit industry. Banks that lend money to various market segments are sustaining losses on their mortgage portfolios, forcing them to tighten the terms and availability of other forms of lending. Some of the lending activities affected by this tightening are accounts receivable financing and working capital loans.

The combination of these factors has created a tough credit environment in which companies may not be able to obtain affordable funding that their finance departments may rely on to supplement working capital. Therefore, companies, both large and small, would be well-advised to look for ways to maximize their working capital and minimize the day-to-day impact of the credit crunch. It is essential that construction business owners accurately forecast the movement of cash in and out of the business to properly control cash flow and better manage working capital requirements.

Making Working Capital Work for Your Business

Working capital optimization can help reduce financing costs and third-party debt, while potentially reducing a company’s dependency on external funding. Maximizing working capital starts with an analysis of critical business processes, such as accounts receivable, accounts payable, inventory and fixed assets. Once this information is collected, companies can begin to optimize the cash available internally by identifying cash recovery opportunities and developing strategies to improve financial performance metrics. Some of the key indicators include:

• Days of sales outstanding (DSO) for accounts receivable
• Average days outstanding for both accounts payable and accounts receivable
• Inventory levels in relation to business volumes

The optimal scenario is to use accounts payable to both fund accounts receivable and inventory. In reality, this is difficult, to achieve. Therefore, the objective is to extend the contractual terms of payments with suppliers and vendors where possible and reduce the payment terms given to customers where possible, which will minimize the funding shortfall inherent in the company’s order-to-payment cycle. Adherence to the payment terms by both the company and its clients needs to be actively managed. Clearly there are wider commercial sensitivities around these actions that will need to be taken into consideration when determining an appropriate course of action regarding payment terms taken and given.

Another important area of focus is on inventory levels, which are more difficult to manage. The key is to actively manage the level of inventory relative to the volume of business. Growth requires increased levels of inventory, which can be a drain on cash flow. During a slowdown, inventory levels may lag at higher levels than would be the norm during a steady state, as they take longer to adjust. But if management understands the dynamics of its business and the required levels of inventory given the current and expected volumes of business, actions can be taken to appropriately adjust inventory levels to minimize any negative impact on cash flow.

Starting from the Bottom

Recently, a large manufacturer of fuel system components for the trucking industry sought help after its past due receivables balance had grown from a normal level of about $250,000 to more than $2.5 million.

The problem arose because the company only kept a hard copy of the accounts receivable aging detail. The file was extremely large and cumbersome and contained limited information on past-due balances. The second problem was collection. Due to time and resource constraints, the accounts receivable staff contacted debtors randomly, without a plan, and based on the amount of spare time that was available.

The manufacturing company needed to reduce the past-due receivables balance to the acceptable level of $250,000 by year-end without disrupting the workload of the accounts receivable staff. A systematic approach was developed for the company that included conducting daily research and collection calls. First, a spreadsheet database was created from the data files and reason codes were assigned to the past-due invoices by type of collection problem. The company could then generate a report that summarized the detail into specific categories, and review the weekly accounts receivable aging detail by collection problem and customer.

By creating this organized recovery plan with a system of checks and balances, the company’s past-due balance was reduced from more than $2.5 million to approximately $100,000, which is 60 percent lower than the previously accepted “normal” level of $250,000.

Starting the analysis process from scratch can be a strenuous and time-consuming undertaking, especially for employees who have other obligations. But once the due diligence is completed and easy-to-use spreadsheets are in place, companies can continue to maximize cash flow without an extensive investment of time.

A Team Approach

The material- and labor-intensive construction industry puts added pressure on the cost of doing business and the demand on working capital availability. After gaining control over accounts payable and receivable, companies must create a cash management culture that sustains working capital optimization solutions over the long-term.

Establishing an internal team made up of specialists from different departments, including project leaders and functional and technical resources, can promote accountability and reinforce this culture. Together, the team can ensure cash generated internally is used properly and collection efforts are conducted on an ongoing basis.

In Times Like These

The credit crunch has companies that already optimize working capital concerned about staying afloat, especially when banks and clients cannot always deliver large payments on time. Now is a good time to identify cost-saving opportunities besides layoffs and reductions in benefits. Cash pooling, lockbox and payment methods used by companies and offered to clients should be re-examined to ensure they are helping to optimize cash flow.

As the U.S. government attempts to bail out banks, reduce interest rates and increase consumer spending, commercial financing is not always readily available or cost-effective. The more business owners can maximize the amount of cash generated internally, the less their companies will be affected by the availability and cost of external credit.
 

Construction Business Owner, July 2008