A pet phrase in the financial arena is “Capital is king.” But is this a case where there can be too much of a good thing? If so, how should you communicate this to your borrowers?
Enough vs. too much
An ample amount of working capital allows assets to be converted to cash quickly, enabling your borrowers to cover current obligations. But too much cash tied up in working capital can prevent borrowers from positive courses of action that will help grow the business, such as expanding to new markets or investing in equipment.
Excessive cash balances also can encourage borrowers’ management to become complacent about working capital. If they have plenty of money in the checkbook, they might be less hungry to collect receivables and less disciplined when ordering inventory.
When cash is generated through debt, rather than improved operating cash flow, there could be even bigger problems. In such situations, borrowers need to earn a higher return on their investments than they’re paying in interest. But those that employ sloppy working capital practices are unlikely to achieve adequate returns. Eventually, debt and interest payments can overwhelm borrowers.
Thanks to reduced interest rates on new debt and higher revenues, some borrowers are stockpiling cash. You might notice that a borrower’s working capital has increased over the last few years or is significantly higher than that of its competitors. Proactive lenders point out the trend and encourage effective collections and inventory management strategies.
Collections must be timely
When a borrower sells on credit, it finances its customers’ operations. Stale receivables — typically any balance over 45 or 60 days outstanding, depending on the industry — are a red flag.
Getting a handle on receivables starts by honestly evaluating which items should be written off as bad debts. Then viable balances need to be “talked in the door” as soon as possible. Enhanced collections efforts might include early bird discounts, electronic invoices and collections-based sales compensation programs.
Dedicated collections staff should be charged with approving and monitoring customer credit, sending out collections letters, and making phone calls for any invoices more than 30 days late. Consequently, they should be among your borrowers’ most dedicated employees.
Alternatively, some borrowers sell or “factor” receivables to a third party at a discount, typically 20% to 30% off the invoice amount.
Inventory: Data and technology help
Inventory is a huge investment for manufacturers, distributors, retailers and contractors. It’s also difficult to track and value. Enhanced forecasting and data sharing with suppliers can reduce the need for safety stock and result in smarter ordering practices.
Computerized technology — such as barcodes, radio frequency identification and enterprise resource planning tools — also improve inventory tracking and ordering practices. These solutions often come with a hefty price tag, but not always.
Handheld replenishment devices are a simple solution manufacturers use to improve line productivity and lower their investment in work-in-progress inventory. Here, line workers press replenishment buttons on wireless devices when they need more materials at their station. This signals a refill request to the forklift driver, who then immediately replenishes the worker’s supply.
Keeping an eye on it
While collections and inventory are significant factors when it comes to working capital management, accounts payable can’t be ignored. Borrowers should never pay a bill the day it’s received. Instead, they should extend terms as long as possible — without losing out on any early bird discounts.
Typically borrowers with the most effective working capital management practices will be the lowest credit risk. Encourage your borrowers to manage their working capital levels wisely, and scrutinize working capital when making new loans.