Speed Up Receivables Collection
Many companies are early payers and late collectors—a formula for squandering working capital. Other companies—particularly project-based businesses and manufacturers of large, costly products with lengthy production cycles—have cash flow problems caused by a mismatch in timing between costs incurred and customer payments. Therefore, efficient management of receivables and prepayments received is crucial. An optimization can yield significant potential.
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Invoicing cycle: The main target in this respect is to get invoices to the customers as quickly as possible. Processes and systems should be aligned to allow invoicing promptly after dispatch or service provision. All disruptions of the process by unnecessary interfaces should be eliminated. Furthermore, companies should reduce invoicing lead times by multiplying their invoicing runs.
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Early reminders/dunning cycles: Experience shows that a number of customers seem to postpone their payments to the receipt of the first payment reminder. Early reminders and short dunning cycles thus have a direct impact on late payments. Best-in-class companies reduce grace periods to a minimum or remind their customers of upcoming payments even before the due date. Establishing direct debiting with main customers is the most effective means to avoid overdue payments.
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Payment terms: Renegotiated payment terms will lead to reduced DSO. The first step is often a harmonization and reduction of available conditions to decrease discretionary application. When preparing negotiations, companies should analyze their customers’ bargaining power and specific preferences in order to identify improvement potential in the terms and conditions for payments.
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Payment schedule: Companies operating in project business should introduce more advantageous payment schemes that cover costs incurred. Percentage of completion (POC) accounting helps to define relevant payments along milestones. But also for companies with small series productions, the introduction of prepayments and advances can significantly improve liquidity.
Rethink Payment Terms with Suppliers
If fast-paying companies are at one end of the spectrum, then companies that “lean on the trade” and use unpaid payables as a source of financing are at the other. Between these two extremes there is a more effective, integrated approach to payment renegotiation that takes into account all aspects of the customer–supplier relationship, from price and payment terms to delivery time frames, product acceptance conditions, and international trade definitions.
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Payment cycle: Payment runs for payables should be limited to the required frequency. Here, of course, country- and industry-specific business conventions apply. Moderate adjustments of payment runs just require some changes in the accounting systems, and tend to be a “quick hit.”
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Avoidance of early payments: Payments before the due date should be strictly avoided. Payments should be accomplished with the next payment run after the due date (ex post). Switching from ex ante to ex post payments is common practice and entails an easily implemented lever for increasing payables.
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Payment conditions: A DPO increase can often be achieved by renegotiating payment conditions with suppliers. Best-practice approach here is to first get an overview of all payment terms in use and to define a clear set of payment terms for the future. Renegotiations with suppliers are based on these new standard terms. It is critical to take into account supplier specifics. For those with liquidity constraints the focus should lie on prices, whereas for suppliers with high liquidity the payment term can often be extended.
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Product acceptance conditions: Connecting the settlement of payables to the fulfillment of all contractual obligations may result in significant postponements of respective payments. Enforcing supplier compliance to stipulated quality, quantity, and delivery dates is also the basis for optimized, demand-oriented supply concepts. Prerequisite is full data transparency on relevant events.
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Back-to-back agreements: Balancing the due dates of receivables and payables helps to avoid excessive prefinancing of suppliers and can even lead to a positive cash balance.
Mind the Trade-Offs
Applying best practices of working capital management also means applying value-oriented management of trade-offs between NWC and fixed assets, and between NWC and costs. The isolated treatment of individual levers has its boundaries and, therefore, all elements of tied-up capital across the balance sheet (fixed assets, inventories, receivables, payables, and cash) have to be considered as a whole. For example, it may be advantageous to acquire a new and more flexible machine (fixed asset) in order to reduce inventories. As another example, negotiations in purchasing cannot only focus on payment targets. The company also has to consider the resulting prices and discount conditions. Therefore, a best-practice NWC optimization is not just a pure reduction of NWC; it is rather a holistic optimization with value creation as the overarching target.
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