Working capital is best described as the funds used to run day-to-day business operations. Whether it’s buying raw materials and services, paying employees or keeping the lights on, working capital is an integral factor in any company’s financial strategy and outlook.
Undoubtedly, maintaining consistent cash flow to pay operating expenses and fund well-thought-out investments is crucial for healthy operations. It can be just as critical for business owners and finance leaders to have clear visibility and control over their company’s untapped working capital — particularly in times of economic uncertainty such as now.
Companies can uncover hidden opportunities by better managing their cash flow and optimizing days payable outstanding. Although many factors lead to payment inefficiencies, by addressing the following three areas, businesses can take steps to optimize their working capital performance and efficiency.
1. Paying too early
Companies strive to pay their suppliers on time. In most cases, payment terms are established at the beginning of the relationship to ensure fair, on-time payment. But often a company pays too early, which is like giving an interest-free loan to your suppliers.
For instance, say a company pays a supplier $500 million annually and has a payment term of 45 days. The finance team inadvertently completes the various combined payments on Day 28, effectively giving the supplier an interest-free loan of $500 million for 17 days. Consider all that a business could do with $500 million across those 17 days. To measure whether a company has a similar gap, review the vendor terms in the contract, invoice or vendor master. Then, measure the terms against the actual payment performance. Finance teams and auditors can calculate the gap between when suppliers are paid versus when they are obligated to pay them.
So, how do such gaps occur? Some of the usual suspects include system inconsistencies, outdated system records, incorrect invoice terms, manual overrides and the exceptions process. To identify these gaps, businesses should connect and compare key points within the source-to-pay process. By comparing contract terms to actual payment performance, finance teams can highlight key problem areas.
2. Paying too late
The second common scenario is paying vendors too late, which can cause issues with supplier relationships. When vendors face consistent late payments, they may negotiate additional terms, penalties or even pad pricing to recapture lost funds and protect themselves going forward.
Additionally, accounts payable teams often deal with an abundance of unnecessary and costly support communications regarding unpaid or late invoices. The time and resources needed to address these issues can be significant, while also eroding supplier confidence.
Identifying and addressing this issue is not so much an opportunity to recover lost funds (at best, it will minimize penalty payments), but it can help identify and eliminate potential risks for key supplier relationships.
3. Modeling payment terms
The third step to optimizing working capital is to model payment terms. For instance, if a company has successfully optimized their current terms but is seeking room for improvement, leveraging a rapid modeling platform will help the company calculate potential working capital gains for certain vendors or categories. This way, it can set specific measurable targets.
A platform that rapidly compares multiple scenarios of net versus discount term valuations could prove invaluable here. For example, consider net-10 with a 2 percent discount versus a longer payment term without a discount (net-90). Based on current financial circumstances, payment amount and cost of cash, which one would be more beneficial? On the other hand, how do the terms compare to industry or supplier benchmarks? By understanding the terms relative to the market, finance leaders can determine if the company is within industry benchmarks based on factors like the size of spend, category and region.
Armed with data and insights, finance leaders can set a customized course of action for different categories, business units, regions and suppliers. Rather than taking the one-size-fits-all approach to all suppliers, they can make better, data-driven decisions to maximize value opportunities and supplier relationships.
Putting it all together
In sum, by not actively managing payment cash flow, a sizable working capital opportunity can be left on the table. While accounting metrics such as days payable outstanding may seem uninteresting, this data can be leveraged to make the most of the dollars that businesses already have on hand. A third-party partner with the right expertise can quickly and efficiently highlight gaps and opportunities to recommend action and measure progress on an ongoing basis. And to continue down the optimization path, knowing, comparing, and modeling around industry and supplier benchmarks can help drive invaluable business impact using payment analytics and insights.
