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In the past few weeks we have been covering important elements of finance processes, including internal control systems as prescribed by Sarbanes-Oxley, and the importance of capital planning to ensure key high level financial facets such cost of capital and return on assets have established goals and are being measured.
Our final topic on finance processes is about working capital. Working capital is the money it takes to run your business on a daily, weekly, and monthly basis. It is the money used to pay your suppliers for materials and the money needed to pay for the goods and services (i.e. inventory and payroll) you have used while you wait for your customers to pay you.
There are three important areas that companies should actively manage in order to get the most from their working capital. Here’s how they are related:
working capital = accounts receivable + inventory – accounts payable
Accounts payable is perhaps the easiest process to control because it simply involves paying the bills. But paying bills shouldn’t just be left to chance; there should be clear policies and goals that direct these activities. But generally, when it comes to paying bills, The Golden Rule should apply. Treat others’ invoices as you wish others would treat your invoice. Basically, that means pay it on time according to the terms. There may be no advantage in paying early, but purposely paying late as a working capital management tool is unprofessional and can negatively impact your business.
You may think you are getting away with paying your bills late, but in reality, if the organization you’re paying late has their act together, then your delayed payment may eventually result in increased prices or reduced service levels. While you may be the customer, do you really want to run you business in a way that elicits frowns and curses when your name is mentioned? Building such a negative reputation can have long term detrimental repercussions.
Ensure you policy states that payment will be made according to terms, with a goal of mailing payment five business days prior to the due date or having funds transferred on the due date for electronic payments (and a supporting measurement that clearly indicates performance in relationship to the goal). The accounts payable policy should also clearly state when invoices should be paid early.
The cash flowing into your business as a result of customers paying invoices is crucial in managing your business’ working capital. Your organization should be actively measuring Days Sales Outstanding (DSO). DSO is the average number of days it takes to collect payment after the sale was made. Typically calculated as [(Accounts Receivable / Sales) X (Days)]. Days would be determined by the period for which you are calculating DSO; for example 30 if you calculate it monthly and 90 if you calculate it quarterly.
One key to managing Account Receivable is to remove delay in invoicing customers after shipment of an order or delivery of a service. These delays consume cash available as working capital. Set a goal to invoice customers immediately after fulfillment. If it currently takes 10 days to invoice a customer, then the goal should be to do it in 5. If it currently takes 5 then the goal should be 2 days. Finding ways to reduce the DSO frees cash formally tied up in receivables so it can be used in ways that provides return and fuels growth.
Prompt invoicing is the most important method to reduce DSO. It is something you have direct control over, plus, why should customers be conscientious about paying your invoice in a timely way if your make little effort to send invoices promptly?
Including inventory as a finance function sometimes causes confusion and skepticism. There is no doubt, however, that inventory consumes financial resources; whether in the form of purchased materials/parts, work-in-process, or finished goods. Those responsible for managing the company’s financial resources and performance should also have the ability to oversee and monitor all three types of inventory.
The purchasing representative might believe they are getting a good deal by buying one years worth of parts, and perhaps they are. But making such decisions impacts the overall financial resources consumed by inventory, especially when you include the cost of ownership.
The responsible financial authority should stay informed of inventory performance, and in response set clear policies and goals for reducing and managing inventory levels through metrics such as Inventory Turns (the number of times that a company’s inventory cycles or turns over per year), Days Inventory (the average number of days of inventory on hand per accounting period), Average Inventory (the starting inventory number at the start of a period minus the ending period inventory number divided by 2), and Cost of Ownership (the total cost of maintaining inventory such as warehouse space including utilities and maintenance, finance costs, personnel, equipment, shrinkage, obsolescence, and insurance).
The overarching goal should be to find ways to reduce all types of inventory while ensuring operational needs are being met. This, as with accounts receivable, releases cash tied up in non-productive means so it can be used to gain return or grow the business.
Managing the working capital processes is just as vital to business success as producing products and services that customers want and that fulfills their expectations. Businesses not actively managing their working capital may find an exorbitant amount of financial resources being consumed in unproductive ways such as growing accounts receivable amounts and hefty inventories.
Taking control of your financial processes increases the chances of your business’ success. In the coming weeks Bizmanualz will be releasing the Finance Policies, Procedures & Forms manual, introducing the concept of well-defined and controlled processes to Finance. It can be the first step in understanding your financial processes, and ensuring you receive maximum benefit from your financial resources.
To learn more about changing your paradigm and using process improvement programs for your organization then attend the next How to Align a System of People and Processes for Results class. If you are eager to learn more about creating more order out of the chaos you are feeling at work then the How to Create Well-Defined Processes class is right for you.