All companies experience highs and lows, especially in terms of liquidity. However, even if you are struggling with cash flow, you must continue to honour your contractual commitments. When it comes to settling with your creditors, it is in your best interest to group them considering two factors: possible fines and your strategic needs.
Several events can temporarily trigger cash-flow problems: a large unexpected payment, a contract which you were banking on falling through or a big customer being late in paying. Above all, it is important not to "play dead" when you find yourself in this situation. It is important to remember that you are also dealing with your creditors and some will not "forgive" you for any late payments. Stay in control to prevent this one-off event from becoming a bigger problem.
Priority n° 1: your tax and social security debts
This may seem obvious, but your overriding priority must be the State, i.e. your commitment to paying VAT, social security and tax. That is because you can quickly be caught up in a snowball effect if you miss payment deadlines, with your debts spiralling out of control. Be aware of hefty surcharges, fines and default interest. Indeed, if your company does not respect its tax and social obligations, you will soon find that public organisations have rather dissuasive recovery methods in place.
Beware of the penalties
For example, if you are late in paying your social security contributions, you will be subject to an increase of 10% of the amount due, with default interest of 7% per annum. Please also be aware that the NSSO can seize your company funds and that the tax authorities have the right to seize your bank accounts, to contact your customers to recover debt, or to hold you responsible as a manager under joint and several liability.
An accessible solution: payment facilities
In order to avoid this, there are many options available to you in terms of establishing a repayment schedule with these public institutions. Your company should ensure it takes advantage of these. Again, the more proactive you are, the easier it will be to negotiate a payment facility. The first step is to contact the organisation in question and propose a realistic repayment schedule. Even though the conditions vary, you will usually have to make a first payment before spreading the balance over a longer or shorter period. Even if you are fined for late payment, you may, under certain conditions, be entitled to a reduction or an exemption if you adhere to the conditions of contract.
Priority n° 2: your key creditors
After addressing your situation with the State, you must turn your attention to your strategic partners, i.e. those who have a decisive impact on the smooth running of your business on the basis that, if you tarnish the business relationship with your main suppliers, the situation could go from bad to worse. After a first screening to identify the most urgent bills and priority creditors, draw up a plan of action in line with your current and short-term cash-flow situation. Identify the debts you can pay immediately and in full. For the others, the right approach is to contact your partner.
Clear and controlled communication
Your goal should be threefold: first, demonstrate to your creditor that you are proactive in dealing with your cash-flow problem and that you care about your business partners. Then you must confirm that your situation is temporary and circumstantial. Finally, keep in mind what you want to achieve, make a reasonable proposal and be prepared to negotiate a satisfactory solution for both parties. For example, you can ask for a monthly payment plan in return for financial compensation (default payment interest, etc.), a formal commitment to long-term collaboration or an increase in order volume.
In any case, in order to stay afloat, you will understand you have to: act quickly, communicate clearly and negotiate a staggered payment plan.
Working capital: far more than just an accounting term
Working capital, also known as net operating capital, presents a picture of the operational liquidity of a business. But there is more to it than meets the eye.
The success of a business actually depends to a significant extent on how it deals with its working capital needs.
The difference between working capital and working capital needs
Within the financial analysis, working capital is just one of the indicators that present a picture of the operational liquidity of a business. It not only affects general management, but also the access to bank credit or the valuation of the business, for example. This is calculated as follows:
Equity capital and other resources in the long term - fixed assets
This allows you to see whether sufficient long-term funds are available to finance the production chain. Where there is a positive result that is indeed the case, whereas with a negative result it is actually the production chain that must safeguard the long-term financing.
It is therefore useful to calculate the working capital needs as well:
Current assets (excluding cash) - current liabilities (excluding financial liabilities)
The result shows the amount the business needs in order to finance its production chain, and may be both positive and negative:
- where working capital needs are positive, the commercial debts no longer cover the short-term assets (excluding the financial). In that case, a business can rely on its working capital. If this is insufficient, it will need additional financing for its operational cycle in the short term;
- where working capital needs are negative, a business can meet its short-term liabilities without any problem. Nevertheless, it is advisable to reduce working capital needs (further).
In short, working capital presents a picture of the operational liquidity of a business, whereas working capital needs represent the amount the business needs in order to finance its production chain.
In other words, it boils down to limiting working capital needs as far as possible, thus increasing liquidity. This is crucial, especially in times of economic or financial difficulty. After all, customers tend to pay later then, while your stocks are increasing and your suppliers are imposing stricter payment terms. As a result, more and more working capital gets 'frozen' in your operating cycle, precisely when circumstances make it more difficult to attract additional financing.
Optimising working capital is not only a question of long-term considerations. In the short term, too, the business can release cash that is not being used optimally, or is being used unnecessarily, more specifically in the purchasing, production and sales processes within the operating cycle.
The working capital and the working capital needs must, above all, be geared effectively to each other. The working capital needs must be structurally less than the working capital itself, preferably with an extra buffer. However, there is no mathematical truth regarding the amount of working capital and working capital needs. Sector, activity and business model can affect this, for example.
The cash conversion cycle reviewed
A good barometer of how great the demands of your operating cycle are on your working capital is the 'cash conversion cycle'. This is expressed in number of days and shows how long money is tied up in your business's purchasing, production and sales processes.
The calculation of the cash conversion cycle is based on:
- the number of days' customer credit (DSO – Days Sales Outstanding):
the average number of days that your business must wait for payment after a product or service is delivered.
- the number of days' stock rotation (DIO – Days Inventory Outstanding):
the average number of days that your business needs to convert stock into a sale.
- the number of days' supplier credit (DPO – Days Payable Outstanding):
the average number of days that your business needs to pay suppliers.
The shorter the cycle, the less capital is held in the business process, which allows you to meet your short-term liabilities and expand your activities.
Simplified presentation of the cash conversion cycle
4 rules of thumb to get your working capital working for you
Although entrepreneurs are familiar with the term working capital, all too often they fail to use its full potential. This is a mistake, because targeted management of their working capital needs can bring huge advantages, both financially and at an organisational level.
How a business approaches that in practice is obviously closely linked to its own specific situation and the sector in which it operates. Below is a number of general rules of thumb:
1. Analyse your business processes
A logical first step is a thorough analysis of your working capital needs, based on the cash conversion cycle. The idea is to clearly identify the following business processes:
- management of your customer payments
How long does it take before your invoices are paid? Why do some invoices remain outstanding? How aware are you of your customers' financial situations?
- management of your supplier payments
What payment terms are you getting? Do you get a discount if you pay quickly? Do you use advance financing?
- management of your production and stock
How far can you deplete stocks without jeopardising production? Can you shorten the production time in order to reduce the amount of work in progress? Do you work according to the Just-in-Time system or have you decided to go for Economic Order Quantity?
You will then find out where there is room for improvement and how you can shorten the cash conversion cycle. The idea is to reduce your working capital needs and, by doing so – by dealing more frugally with the available capital – increase the return from your general management.
2. Collect faster and better
Adequate monitoring of your accounts receivable is crucial. Relatively small, obvious interventions can sometimes produce a surprisingly big benefit. Here are some tips:
- Monitor the quality of your invoices. A good invoice will quote a correct amount, a payment due date and will be received promptly by your customers.
- Invoice smaller amounts on a regular basis and avoid summary invoices where possible.
- Actively follow up outstanding invoices and find out why they remain unpaid. Is it down to the customer's financial situation or are there other factors to consider? Disagreement over the amount charged or problems with the delivery or sale often cause delays or result in non-payment. By aligning your accounts and services more efficiently, you end up with a win-win situation: satisfied customers and fewer disputed invoices.
- Solutions such as factoring or direct debit are a particularly profitable route to take. These lead to swifter collection without putting pressure on your customers or tightening up your payment terms, which is always delicate in a commercial relationship.
A clear picture
Without an overview of your accounts at home and abroad and of your incoming and outgoing payments, management of your working capital is virtually impossible. So, you need clear, immediately available information and reporting. Different solutions for electronic banking, reporting arrangements with your financial partners and efficient operation of your accounts and bookkeeping will help you considerably here.
Another profitable route is the centralisation of your cash and cash equivalents, which will dramatically simplify both the management and monitoring of these. Often this also offers numerous options in terms of fiscal optimisation.
3. Make optimum use of your supplier credit
Making sure your invoices are paid systematically in order to build up your number of days' supplier credit seems a painless and effective intervention, but it is the least you should do. After all, there is a good chance that the supplier will pass on the charge for the longer payment term in the price you pay for subsequent deliveries. There are a number of better alternatives:
- See whether or not it would benefit you to pay more quickly – in many cases early payment carries an attractive discount.
- Choose solutions that let you pay later without the other party being affected. For example, by relying on lines of credit or working via reverse factoring, whereby the supplier receives an advance on your payments from the bank.
- Negotiate with your supplier for an extension to your payment terms.
Ensure you have adequate protection
Being able to get hold of your funds quickly is just one aspect of optimum management of your working capital. Another is the assurance that your customers will actually pay, while at the same time your business must project confidence to (potential) trade partners. To that end, you can call on the various forms of documentary credit. By engaging credit insurers, you are also hedging the risk of the other party defaulting on payment.
Another important factor, certainly as far as international transactions are concerned, is the exchange rate risk. Although you may know when you are going to get paid, the exact amount depends on the exchange rate at the time of payment. Because the difference between a good and a less favourable exchange rate can have a big effect on your margin, you are better off hedging yourself against possible exchange rate fluctuations.
4. Get maximum performance from your stocks
The financial impact of your inventory control should not be underestimated. Just think about invoices that are outstanding after a faulty or late delivery, or holding on to too much stock of slow-selling products. The advantage of the latter is that you can always deliver promptly, but it does freeze a major part of your working capital. A few guidelines:
- Check your stocks and prices regularly, preferably using a package like Enterprise Resource Planning (ERP) or a web-based application with direct link to your opposite parties.
- A warehouse management system will allow you to retain a good overview of your quick and slow-selling products, so you can adjust your stock accordingly.
- Keep your finger on the pulse of the market so that you can correctly assess demand, and thus avoid stock surpluses or deficits.
- You can also choose a radically different course and outsource your stock management to a logistics service provider.
- Use stock financing to keep cash and cash equivalents available for other purposes.
- Hedge yourself against price fluctuations on the raw materials markets, to protect your margin.
An exercise in balance
Optimising your working capital needs is therefore a continual exercise in balance between your accounts receivable, accounts payable and inventory control. It is a stiff challenge, but essential if you are to increase your financial might and steal the march on your competitors. Get your working capital to perform!
How does the bank assess a credit application?
Before providing credit, the bank needs to have confidence in you as a creditor and the project to be financed.
There are five important factors in assessing a credit application:
1. Confidence in the borrower and the business plans
First and foremost, the bank will want to make a clear assessment of the risk of non-repayment of existing and new lines of credit. To make a balanced appraisal, it will therefore want to find out about any aspects of the company that might either support or jeopardise its continued existence.
Most banks express the risk profile of a company in the form of a credit rating. They use specific internal statistical models to measure:
- Qualitative aspects: the experience of directors and management (because they play a key role in the business), the quality of how the activities are managed (e.g. production, accounts, audits, etc.), diversification in the customer base, the products and services, the suppliers, etc.
- Quantitative aspects: the liquidity, solvency and profitability of the borrower, use of existing credit lines, etc.
How can you anticipate?
- You should present your company in detail so that your relationship manager gains a clear understanding of the business activities, the inherent business risks and any ways to mitigate these risks. Be as complete as possible. Otherwise your relationship manager will have to ask for additional information and the decision-making process will take more time.
- By bearing some of the risk yourself in proportion to the credit required. If you contribute a portion of the required finance yourself, the financial burden and risks are shared more evenly between yourself, as the borrower, and the bank. Furthermore, it also demonstrates your belief in your business and the project to be financed; this will only benefit your application's chances of success. There is no fixed formula for how much risk you should bear yourself. The higher the bank assesses the risk, the greater the contribution the bank will expect from you.
These points are especially important when embarking on new credit relationships in order to build mutual trust. But even when you already have a good credit relationship with your bank, these points still benefit the continuation of that trust.
2. Clear credit purpose
The bank expects to have a clear understanding of the planned use of the new credit finance.
How can you anticipate?
- Don't just mention the reasons for and benefits of the investment project, also describe the risks and the impact on the current business operations.
- Indicate when you expect a credit decision from the bank and when you would need the funds.
3. Sufficient ability to meet the repayments
The bank will want to assess the future ability of your company to meet the repayments, based on both current activities and new developments.
For current activities, the bank will start by examining past performance. For instance, has performance been stable or unpredictable? Assessing additional ability to meet repayments from new activities to be developed (and therefore based on forecasts) will, of course, be much more difficult. The bank will therefore be very cautious about any forecasts.
How can you anticipate?
- By supporting your forecasts properly: how do you intend to achieve the positive figures forecast? Who will be responsible for which actions?
- Do not just assume positive scenarios; prepare a contingency plan too. What can you and should you do in the case of unexpected difficulties?
4. Risk mitigation in the form of real security or guarantees
Generally, the bank will request security and guarantees to minimise the risk that it bears (and therefore its loss if you can no longer repay the credit facility). The most common forms of security are a mortgage charge on property or a pledge on assets, such as stock and/or receivables.
However, providing real security may not itself be enough to be approved for credit. The bank places far greater importance on the borrower accepting some of the risk and sufficient ability to meet repayments.
How can you anticipate?
- By agreeing to grant your bank a preferential right to the goods that it has a key role in financing. In the event of failure or liquidation, this will prevent the proceeds of the financed goods from going to creditors that did not contribute to the financing. The enforced realisation of real security does not always raise enough capital to cover the outstanding credit sums and interest due.
- By providing information about the distribution of your lines of credit and guarantees (and the order of priority of registration) among your banking partners.
5. The operational relationship
It makes sense that the bank that provides you with credit will also want to see the cash flows generated by this finance (needed to meet your credit repayments) go through its accounts. This allows them to grow the credit relationship to a fully-fledged operational relationship, which is vital under the new Basel III regulations. The cash also enables the bank to grant further credit.
How can you anticipate?
- By assigning a portion of your incoming and outgoing payments (the "float") - and the deposits that they generate - to your bank, in proportion to the amount of credit provided and for the term of the credit facility.
- By providing transparent information on how your incoming and outgoing payments - both domestic and international - are organised and where you intend to keep any surpluses.
It pays to prepare and document your credit application well. Openness and transparency are the keywords. Both your company and the bank have an interest in a realistic assessment of the application in order to avoid any possible repayment problems.