As the autumn chill bites, you should be thinking of wrapping up the current financial year and preparing the budget for next year. Even though the financial year is drawing to a close, you still have time to give your working capital and balance sheet an overhaul before the Christmas party season gets into full swing.
Most companies which supply goods and services to customers also send out invoices with various payment terms. This means they have agreed to supply goods and services now and receive payment later. In the meantime, the supplier recognises the amounts due as trade receivables in the balance sheet. These trade receivables tie up company capital and also involve significant risk. What if your customers are late paying? What if your customers default on payment?
Payment terms have been getting steadily longer for many years. It is now not unusual for suppliers to have to wait for their money for 2–3 months. You should therefore be looking at how you can finance your business while waiting for payment for deliveries that have already taken place.
Not only do trade receivables tie up capital, but they also involve an expense. This expense varies from company to company according to capital structure and required rate of return. As your customers demand ever longer payment terms, more capital is tied up, leading to mounting costs.
The business transactions you recognise as trade receivables are recognised as trade payables by your customers. These trade payables effectively represent an interest-free loan from the supply chain and it is easy to understand why your customers would want to extend the payment terms for their purchases. A balance sheet swelled by trade payables releases tied up working capital and improves turnover of capital.
It goes without saying that customers have a strong incentive for wanting to extend payment terms. Conversely, it is in the supplier’s interests to shorten payment terms. More often than not, this conflict ends with you, the supplier, having to accept that the customer is always right.
How much cash do you have tied up in trade receivables?
Working capital has been a hot topic for years, alongside payment terms and trade receivables. Working capital is capital that is required by the day-to-day operations. The actual amount of available working capital is subject to a dynamic interaction between three factors:
– Trade receivables tie up capital because of postponed payments due to payment terms and delays. The longer the payment terms, the more trade receivables swell the balance sheet and tie up capital.
– Current assets, e.g. inventories, also tie up capital.
– Trade payables are liabilities that are subject to payment terms agreed with suppliers. The longer the payment terms, the more trade payables swell the balance sheet, releasing working capital.
One way in which you could optimize working capital would be to increase your trade payables. But agreeing longer payment terms involves exhausting negotiations and new contract terms and conditions with each and every supplier. Plus, suppliers could end up in financial difficulties or a cash crisis due to longer payment terms. This is bad for buyers, too.
Have you done your autumn tidy-up?
Most companies’ financial goals include not only sales and profit, but also management of employed capital, increased efficiency and improved cash flows. Even though the financial year is drawing to a close, you still have time to influence your working capital.
You could outsource invoice processing to an external service operator, and a complete business process outsourcing partner would also be able to provide a receivables management service. Management of customer relationship risks is more efficient when handled by a partner specialising in this sector. It is difficult to predict cash flows when customers pay their invoices late and late payments also tie up capital in the balance sheet. Overdue receivables increase the risk of bad debts and you should take steps for immediate collection.
Avoid sleepless nights and sell your trade receivables to an outsourcing partner instead of burdening the balance sheet.
Do this either when they arise or no later than when starting the collection process. Now is a good time to decide which trade receivables you want to keep on your balance sheet at year-end.
Lauri Holländer is Senior Sales Manager at Arvato.
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