Economic uncertainty worldwide is growing, with the U.S. presidential election coming up later this year and trade wars afoot, as well as fears of a possible recession—and let’s not forget the coronavirus pandemic, which has been roiling stock markets around the world for the past couple of weeks. Business confidence among top U.S. chief executives was tentative even before the coronavirus arrived in-country, as evidenced by the Business Roundtable’s CEO Economic Outlook Index.

The Economic Outlook Index metric captures a composite view of CEOs’ plans for capital spending and hiring, and expectations for sales, over the next six months by surveying executives from nearly 200 companies. After falling more than 10 points in the third quarter of 2019, the index fell another 2.5 points in Q4—the seventh consecutive quarterly decline. As Joshua Bolten, president and CEO of the Business Roundtable, puts it: “American businesses now have their foot poised above the brake, and they’re tapping the brake periodically.”

What’s more, central banks are engaged in a very active currency war. They are continuing to lower interest rates with the goal of making their bonds less attractive and depreciating their currency, to make their exports more competitive on the global market.

Many companies are responding to this chaotic business landscape by attempting to grow their cash reserves. However, if they’re focused only on accessing external financing, they may be overlooking a large, hidden source of capital that exists in their own balance sheets. Raising financing can take as long as six months and requires significant effort from both the CEO and CFO. Other working capital management strategies can produce faster returns without increasing the company’s risk profile.

Most organizations have numerous options for freeing up net working capital, including strategies to improve accounts receivable (A/R), accounts payable (A/P), inventory, and cash management. Finding and capitalizing on these opportunities requires the ability to see what’s coming, without being blindsided. It’s also vital for treasury and finance teams to be creative.

Here are four suggestions for crafting a strategic and proactive approach to managing working capital in the face of external markets’ uncertainty.

 

1. Leverage A/P automation to improve treasury’s view of working capital.

All organizational decision-makers need the guidance of a financial dashboard. Just as a pilot relies on various gauges on the plane’s instrumentation panel to chart a flight path, executives require a dashboard that they can use to monitor changes in business parameters that might affect the company’s chosen path to profitability.

For the corporate treasurer, three reports are critical in supplying data to populate this dashboard: the net income statement, cash flow statement, and balance sheet. In addition to this month-end financial data, the A/P department typically provides treasury with information on what the company owes suppliers, and when. Visibility into the company’s true financial position—including open invoices, invoices in processing, etc.—is critical in populating forecasts and developing a cash plan.

The best way for A/P to give the treasury group such visibility is to provide the following key metrics:

  • Open A/P invoice amount. The sum of the dollar values of all invoices currently received but not paid.
  • Cash requirements. Overview of what amount is due when. All invoices in transit throughout the organization will have to be paid, but when? It’s vital to know exactly what amount needs to be paid and in what timeframe.
  • A/P workflow status. Understanding where invoices are within the invoice processing and approval workflow can also provide insight into how likely the company is to be able to pay suppliers on time.
  • “Live” DPO tracking. A useful dashboard view offers the ability to compare how days payables outstanding (DPO) is developing monthly, with a year-on-year overlay to discount seasonal variations from the analysis.
  • Unpaid invoice categories. Invoice aging categories that specify reasons why amounts are unpaid can clarify the organization’s true position. A decision not to pay is very different from the inability to pay due to liquidity or process issues.

Today’s A/P automation solutions can also provide pertinent data in real time, including competitor benchmarks, to help organizations track their performance and navigate effectively in the “new normal/not business as usual” environment. With millions of transactions running through them, they can aggregate statistics on process performance and financial data that provides critical benchmarks to enable organizations to execute in an informed manner.

For example, DPO is a key metric in uncertain times, yet many businesses never know what their optimal DPO should be. Understanding the industry standard at any given time via benchmarking offers powerful insights for supplier negotiations. There is a direct link between available working capital and DPO (and, of course, days sales outstanding—DSO—as well). Knowing whether to attempt to drive higher DPO out of suppliers is a delicate balancing act. If the organization knows what payment terms other buyers in the region/industry/market are offering, or requesting from, suppliers, decision-makers can more confidently identify opportunities for extending DPO.

 

2. Use corporate spend data to shore up the supply chain.

Trade wars, disruptions, and a landscape of evolving tariff policies impose new risks on suppliers. Thus, de-risking the supply chain is imperative in times of economic uncertainty. Many suppliers around the world are currently feeling the squeeze from the coronavirus. This stress comes in the form of supply shortages, cash shortages (resulting from lost sales due to supply shortages), and/or reduced sales due to cascading upstream effects (e.g., companies cannot fulfill customer orders because their own suppliers face supply shortages).

Tariffs may have a similar effect on businesses. They increase the cost of procuring goods, thereby squeezing margins or lowering sales. Many suppliers that took advantage of lower labor costs through overseas manufacturing are now seeing these cost benefits eroded by tariffs, or by higher shipping costs that result when shifts in trade flows create more demand on transportation systems and routes become more costly. They are financially stretched to the point of near-breakage; if payments are not timely, they may soon go out of business.

In times of economic uncertainty, organizations will want to help and support, as much as possible, all their vital suppliers that may be subject to disruption. Global organizations need to understand which suppliers they can replace fairly easily, and which supplier relationships are absolutely vital to their business. This information, in turn, will inform decisions about how much the company needs to work to support a particular supplier and where it can best afford to squeeze a bit harder to extend DSO.

The first step is to segment the company’s supplier pool. There are various methods of supplier segmentation, but one of the most popular is the Kraljik matrix, first introduced in 1983 by McKinsey & Company consultant Peter Kraljik. This method examines all corporate purchases along two axes: supply risk and profit impact.

Every supplier is subject to some level of risk that an unexpected event will disrupt its operations; the level of this supply risk varies based on factors such as geographic location, business model, and extensiveness of the supply chain. The profit impact is the extent to which disruption to that supplier’s business would impact the profitability of operations of the company doing the analysis. For example, in the case of an automaker, a negative consequence to a steel supplier is much more critical to the bottom line than a problem with an office supply vendor.

Kraljik recommends sorting purchases into four categories, then applying targeted strategies to each group of suppliers. This might look like:

    • Strategic suppliers (high supply risk, high profit impact) and “leverage” suppliers (low supply risk, high profit impact). The procurement team likely already has a solid understanding of how to sustain a win-win relationship with the company’s suppliers of direct materials. That said, there are usually a few non-production suppliers that, while critical, are not associated with a specific internal supply chain manager and therefore remain outside the company’s standard supplier management processes. If partnership with a strategic or leverage supplier is important to the company’s success, treasury needs to be aware of how the supplier would be impacted by a potential recession. If treasury determines that the supplier is short on cash, the company can decide whether to employ classic supply chain management strategies to mitigate the risk. In such a situation, the company may want to consider dual-sourcing in the future to mitigate the mid- to long-term risk posed by that supplier.
    • Bottleneck suppliers (substantial supply risk, low profit impact).  The company should be sure to pay these suppliers on the due date, but not go out of its way to employ sophisticated supply chain management strategies. The low profit impact means the supplier does not warrant too much effort, but the supply risk means the company should avoid upsetting this supplier if there’s nothing to gain from the conflict.
    • Suppliers of non-critical items (low supply risk, low profit impact). The goal should be to try to minimize the cost of transacting, and even perhaps earn card rebates by paying through virtual credit cards.

 

3. Strategically leverage different working capital tools and strategies with your different supplier segments.

Late payments to suppliers have been part of the finance playbook for many years. In the short term, organizations will have more available net working capital if they extend DPO. In the long run, however, many organizations have seen this strategy backfire, when they are left struggling with a shrinking pool of suppliers that are increasing prices in an effort to stay afloat. Suppliers that are experiencing cash flow difficulties—perhaps as a result of tariffs or other trade disputes—may be severely impacted by an increase in DSO (DPO, from the customer’s perspective).

Alternatively, companies starting from a strong cash position can help shore up struggling suppliers’ cash flows by paying early—and reduce their costs by negotiating early-payment discounts and also by pursuing volume rebates.

Selling internal management on these strategies should be straightforward. For example, suppose that your company pays the full amount of an invoice on day 10 rather than day 30, for a reduction in price of 2 percent. That’s equivalent to lending the supplier money every 20 days, for a 2 percent return over that period. Each year has 18 such periods, so your early-payment program essentially earns 2 percent 18 times over the course of a year. Considering the compounding nature of interest (putting the earnings from each period back into your money machine—so in the second 20-day period, earning 2 percent interest on a principal worth 102 percent of the value of your original principal), such an early-payment discount will net total returns of 43 percent annually.

The math behind early payment discounts is jaw-dropping. Einstein said, “Compound interest is the eighth wonder of the world. Those who understand it, earn it. Those who don’t, pay it.” In a low-growth economy with low interest rates, a treasury team would be hard-pressed to find a better way to leverage company cash to drive such significant returns.

At the same time, a company doesn’t have to accept early-payment discounts just because a supplier offers them. If cash on hand is deficient or the capital outlay exceeds the benefit of the discount offered, it may make sense to pay later. However, with interest rates generally low and financiers looking for risk-free investments, it might also make sense to borrow to finance early payments. Debt payments of 6 to 10 percent annually (depending on the company’s industry, region, and credit rating) may be worthwhile if they reduce costs of a significant input to the business by 43 percent annually.

Treasury teams need to leverage their structured A/P data to choose the most advantageous payment terms, and most appropriate payment timing, for each vendor. They should set goals that fit the company’s current position and desired future state—for example, in year one, the goal may be to move non-critical suppliers to virtual card payments in order to capture card rebates. This is a low-effort action that can deliver a noticeable yield.

 

4. Monitor supplier performance.

Once terms have been negotiated, the A/P and treasury teams need to work together to capture data on the supplier relationship on an ongoing basis. Both teams should have easy access to information on all invoices received, and on reconciliation of invoices with payments. Together, they should regularly review contracts and update payment terms to flag opportunities for discounts or other working capital considerations.

There are several specific issues treasury should periodically reconsider to ensure that the company is optimizing value from its supplier relationships:

  • Two of the most important and value-added data points for treasury are the answers to: How much is money worth today? And how much has the organization paid to have our current level of cash on hand (e.g., interest paid to a bank or other funding source)? Treasury needs to be able to answer both of these questions at any time to support corporate leaders in defining the company’s position on early-payment discounts.
  • To understand the “what-if” impact from changing payment terms on a supplier bucket/segment, organizations must be able to quickly summarize their total spend within that segment. Total spend data should come from A/P.
  • Treasury should have dashboards in place to track actual execution and ensure alignment with the company’s overall supplier strategy and segmentation plan.

Not only do these efforts help ensure that payment terms are optimized, but they also improve the quality of the company’s cash forecasts and treasury’s ability to accurately anticipate short-term liquidity needs.

Another element of reviewing supplier relationships is monitoring internal compliance with procurement standards. To avoid overspending or trading with unapproved suppliers, the company should issue a purchase order (PO) for each new order and have a mechanism for confirming that each PO abides by the agreed-upon terms the company has negotiated with that vendor. Spend transparency is crucial.

 

Rewriting the Rules of the Finance Playbook

Organizations have little control over external inevitability, such as changes to the political climate or rapidly spreading diseases. However, companies can gain greater confidence during uncertain times by ensuring that their internal operations are governed by visibility, efficiency, and controls. Access to complete data on purchases and supplier relationships is imperative, as is collaboration to foster new and creative working capital strategies that enable the organization to drive growth and profitability, whether the best-case or worst-case scenario plays out moving forward.

Today, tomorrow, and in the future, cash will be king. Collaboration that unites procure-to-pay operations, treasury, and risk management teams can guide organizations to optimal working capital strategies, keeping them on the path to profits.

 


Daniel Saraste is senior vice president of strategy and innovation at cloud-based A/P automation vendor Medius. Based in New York, he has nearly 20 years’ experience in spend management and net working capital optimization, from having worked with global clients in the retail, manufacturing, and oil-and-gas sectors.