Find and improve Working Capital within your business – Focus on Payables:
This is the second of four Profit Gap blog posts focusing on the key elements of Working Capital. Our initial post on this subject explained our view of Working Capital in broad terms. In this post we will “drill down” on Payables, one of the key Working Capital elements.
Note: For many Profit Gap subscribers, this information will be familiar as we consider this to be an important opportunity to conserve cash and build working capital. What follows is similar to what we published in September 2015, it was originally written by one of our Associates, Elizabeth Pearce, and in this case edited to reflect the Working Capital theme.
Accounts payable: A Two Edged Sword.
Many small businesses simply pay their suppliers as soon as the bill arrives. While this policy may endear your company to the purveyor, it may not be the best use of company cash. One of the most powerful tools for managing your firm’s liquidity (and maintaining Working Capital) is the credit provided to your firm by your suppliers. Your bank may change your Working Capital Credit Line every 1 to 3 years, but as your business grows, so do your purchases with your suppliers and payables thus become an ever increasing source of potential working capital. When a firm uses vendor credit such as this, it resides on the Balance Sheet as Accounts Payable within the Current Liabilities.
Liabilities are essentially debt which leverages the owner’s assets in the company. But every liability is a claim on future cash generated by the company. When company earnings are positive using Accounts Payable debt to increase financial leverage, increases earnings. But when the economy turns down, or competition increases and sales decline, debt repayment can add to the challenges.
Accounts Payable as a source of working capital can be, therefore, a two-edged sword. Suppliers are providing the credit and are knowledgeable about your industry – for better or worse. They hear about the industry from multiple sources, including your competitors. To effectively manage and level the playing field, you need to understand your position, debt level and margins relative to your peers. This is where a tool like Profit Gap can help.
This company has set its Payable goal to 40 days as those are the credit terms they have with their suppliers. With this report, it knows that the best in class in its industry probably have 58 day payment terms, and the top 25% of companies in the industry have 48 day payment terms with their suppliers. This company’s Payables, relative to Cost of Goods Sold (which track Revenues) are currently at 28 days. The company is paying its bills four days faster, than the average company in its industry and twelve days faster than its goals. Elsewhere in the Profit Gap report, the Profit Mastery Assessment page, Hello Telephone is told that given the information in their QuickBooks for the company, each day of this ratio is worth about $9,000 shown below circled in red.
So that is $106,668 ( that the company has paid to suppliers that could have been retained by the company as working capital… if the Payments were made 12 days later.
Businesses build on this: Bill Bindley built a multi-billion dollar business (Bindley Western) from a small start-up, with almost no initial capital. When Bill started his drug distribution business, it was out of his station wagon. Drugstores paid him in 15 days and he paid the drug companies in 30 days – so his firm was started on the working capital float that was generated by the business.
Keep reading, THIS IS IMPORTANT: Maximizing the use of vendor credit carries a higher debt load, but as long as your balance sheet has the Current Assets to cover the debt there should be no issues… and utilizing your own working capital is far less expensive than other forms of credit, as it has no interest!
Paying as late as permitted is a great strategy for improving a company’s working capital position. But paying later than the credit terms you have with your suppliers can cause the credit to be reduced by the supplier impacting your available cash.
So, supplier credit works both ways. The wise company owner finds a way to monitor the amount of credit available, how much is being used and how quickly the bills are being paid.
The Accounts Payable expressed in Days, is a useful way to understand Accounts Payable and available working capital relative to the size of your business. Profit Gap does the calculation and helps owners understand their financial position and to find these Working Capital opportunities. Knowing where your cash is and where you can take advantage of Payable credit terms can significantly improve your cash flow and working capital.
FinancialSoft is dedicated to helping small businesses prosper. Its Financial Reporting Systems provide business intelligence to help company owners increase Cash Flow and Profits thru a better understanding of their financial statements and how to use them to guide company decisions. FinancialSoft Financial Reporting Systems include Profit Gap (Modeled after Profit Mastery teachings) and eFO (electronic Financial Officer). For more information, visit www.financialsoft.biz