Optimizing Working Capital without risking Supplier Relationships
Yesterday I had listened of two vastly different stories about how two different Global 2000 organizations managed their suppliers. Each had differing results, with some unintended consequences. The differences almost reminded me of the polarity of magnets and how the same two items can become so opposed to, or drawn towards, each other by just a simple tweak in positioning. Take one of the objectives of all corporations: optimizing working capital.
Working capital is one of the most important indicators of efficiency within the supply chain for both buyer and supplier. To some, it reveals more about the financial condition of an organization, and commonly used in valuation techniques such as Discounted Cash Flows Analysis.
Working Capital = (Current Assets – Current Liabilities)
Effective management of working capital aims to minimize capital tied up in an organization’s turnover process by reducing what is tied up in cash – (e.g. accounts receivables and inventory) while extending payment terms related to accounts payable. These goals can offer difficulties and dictate a tradeoff between risk and profitability; therefore, in place of “maximizing” working capital, we often hear about “optimizing” working capital, as many consider a low-level positive WC as optimal.
This brings us to the Cash Conversion Cycle or CCC, a metric that expresses the length of time in days that it takes for a company to convert resource inputs (e.g. inventory) into cash flows
CCC = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO)
Some say that this equation may very well be the most important indicator in optimization and a true measure of “liquidity risk”. In fact, according to a study by Garcia-Teruel and Martinez-Solano in 2007, the effect is so significant that they found a 25% reduction in CCC resulted in an increase in the enterprise value of approximately 7.5%. Though optimal is 0 days, the industry average is 36 days (Data presented on the REL study on 1000 companies from a presentation at the MNAFP Annual Conference April 2011).
Where am I going with this?
Any buying organization understands that an effective way to reduce their CCC is by increasing their payable cycle versus attempting to reduce collection cycles with own clients. Of course reducing DPO has a ripple effect – by extending payment terms with suppliers it impacts their working capital.
Furthermore in this economy, suppliers continue to find it difficult to gain and maintain access to working capital financing. Reduced liquidity and margins have resulted in damaged buyer-supplier relationships, as well as increased risk to the supply chain as a result of the additional cash flow strain.
The Result: Two magnets violently opposing each other, without the perspective that a slight shift in orientation would benefit both sides. If buying organizations can extend payment “terms” (note the emphasis on terms), while providing the supplier the relief they need, both sides can win. Commonly this is referred to as “factoring”, or “supply chain finance”. With supply chain finance, however, the assumption may be that a third-party institution is involved in the financing, but this is, ultimately, an option of the Treasurer based on their goals and return on investment.
Let’s start with the premise that suppliers do not care what the payment “terms” are, so long as it benefits them overall. Therefore, in this economy where small business working capital rates are hovering around 7.14% to 8.19% (that is if the company can secure a loan, with or without personal assets being factored into the equation), many will voluntarily forgo a small discount for earlier payment, known as Early Payment Discounts (EPD). In fact it has been shown that, on average, roughly 50% of the spend is willing to forgo 2% of the value for early payments. This equates to 1% of the total spend.
(I will pause for everyone to quickly calculate that impact on your own company).
How does this benefit the supplier? If, for example, we use $1,000,000 outstanding, at 7.665% interest rate (average from above), the cost of debt on 60-day payment terms is $12,600.
If we adjust to payment within 5 days, at 2% discount, the cost is $4,063 (5 days at 7.665%, and 55 days at 2%) – this is a $8,536 savings to the supplier. Further, for the buying organization, the commercial return on treasury funds is significant. A 2% 10 Net 30, for example, is equivalent to roughly a 36% APR!
The result of EPD can be a collaborative win-win for suppliers and buying organizations by further minimizing supply chain risk, easing cash flow pressures on suppliers, and reducing costs for both the suppliers and the buying organization.
Magnets can attract by providing a means for buyers and suppliers to effectively communicate and leverage the benefits of EPD. This be accomplished in the following steps:
1. Leverage a Supplier Management platform for supplier enablement, which can target, recruit, onboard, and support suppliers;
2. Capture current contract, or other, payment terms;
3. Automatically communicate the objectives to the suppliers;
4. Intelligently recruit the suppliers to enroll into the system
(note: this varies based upon industry, as: Energy & Utilities may not be able to discount, Real Estate Services may discount under 1%, and Industrial Equipment & Supplies may be willing to offer up to 2% – and surveying and understanding their threshold is important in maximizing what to offer and to whom)
5. Enable suppliers to validate their new “terms” online, as well as their agreement on EPD rates moving forward
6. Automatically syndicate to the downstream system what the new payment percent and terms will be
7. Enable the supplier to efficiently upload their invoice into the Supplier Management system, and track progress for cash flow predictability; and,
8. Watch your savings drop straight to the bottom line!
The remaining question is: if our treasury funds are financing this initiative, wouldn’t that negatively impact the balance sheet? The answer is yes, but with organizations increasingly holding onto cash reserves at low rates, this may be a better investment than others. However the option remains for utilizing a third-party provider to finance this activity, which will undoubtedly be at a significantly lower rate than the return of 36% APR.