The Role of A/R in Optimising Working Capital

Sustainable working capital provides a company with the flexibility to expand and enhance its operations, improve liquidity, maintain or increase profitability and respond to challenging economic conditions. Yet all too often money can become tied up in the accounts receivable (A/R) entry on the balance sheet, something that firms looking to optimise working capital have often overlooked as part of their financial strategy.

The importance of unlocking funds in the A/R entry is exacerbated by the economic climate and the continued reluctance of banks to lend. Indeed, innovative firms are looking internally to raise funds by taking a customer-centric approach to improve A/R and therefore optimise working capital.

Historically, firms have looked to optimise three key aspects of working capital – namely cost cutting, inventory management and by obtaining best possible returns on cash reserves while prolonging the accounts payable (A/P) process. These functions are already considered strategic, yet A/R, often the largest entry on a balance sheet, has traditionally been more of an administrative concern. However, as the fourth key factor of working capital, A/R offers an untapped opportunity for innovation in optimising working capital. A rethink is required to ensure that the credit, collections and complaints functions unlock the true value tied up in A/R and therefore become a strategic concern. If done successfully, this will not only keep cash flowing through a business, but will free up funds for investment in future growth.

Turning from Tradition

Throughout the economic crisis, cost-cutting has been at the heart of most strategies, meaning that the majority of firms are now as lean as they can be without affecting performance. Moreover, long-term inventory management strategies are well supported by logistics theories and systems, meaning that the potential for further improvement is minimal. The same can be said for cash management, with larger corporations applying sophisticated strategies to manage and use their daily international cash reserves.

However, there is a ceiling in the short-term to the potential returns realised from cash and money market instruments. Lessons learned over the last few years have shown that relying on these liquid asset classes or stable interest rates is no longer a safe bet. Meanwhile, A/P is often the subject of short-sighted policies. Granted, firms can improve liquidity by withholding payment of invoices to protect cash, but this is not a sustainable strategy since monies owed will ultimately be collected. Furthermore, such an approach has contributed to an increasingly noxious business climate in which cynicism has replaced trust as companies withhold payment for their own short-term benefit.

Such shortsightedness has had a detrimental impact across the wider economy because whether by accident or design, late payment limits liquidity and has a knock-on effect throughout the supply chain. Figures released last year by Bacs, the UK electronic payments scheme, revealed that SMEs were owed £24.6bn and were waiting 39.4 days beyond the agreed terms for payment. Moreover, research commissioned by business finance specialist Bibby Financial Services suggests that chasing late payment costs the small business community as much as £1.9bn a year.

And it’s not just smaller firms that are affected. Analysis by working capital consulting firm REL concluded that the fallout from the economic crisis has made it dramatically harder for companies to collect from customers and manage inventory. According to REL, with firms holding back payments to suppliers, rises in days’ sales outstanding (DSO) and days’ inventory outstanding (DIO) during 2009 resulted in up to US$740bn in cash being unnecessarily tied up in working capital at the 1,000 largest public companies in the US. Whether legislation, such as the European Commission’s (EC) amended Late Payments Directive, can be enforced effectively to address this issue, remains to be seen. The fact is that, while an organisation might perceive itself as a valued partner in the supply chain, the supplier-customer relationship is perilously fragile and under pressure as never before.

Winning the Late Payment War

In a perfect world, invoices flow from supplier to customer and money from customer to supplier in the most seamless fashion possible. Yet in today’s business environment the payment of invoices is a battleground. Adopting a strategic and customer-centric approach to credit, collections and complaints management not only allows firms to counter this war of attrition and unlock the value of their A/R, but will directly improve their profitability by reducing the financial risks posed by write-offs and late payment. This model also promotes a decent way of doing business, in which all companies are able to fulfill their duty to pay in a responsible manner.

What does a customer-centric and strategic approach to credit, collections and complaints management entail? First, it is about recognising how A/R management operates at the very heart of the supplier-customer interface. By understanding and analysing customer behavioural information using qualitative analysis, detailed reporting and key performance indicators (KPIs), it is possible to segment the customer base and apply appropriate action profiles to minimise payment times. This reduces DSO, while identifying and targeting the weakest customers to enable informed decisions on the terms and conditions to be applied to future transactions.

Second, the ability to segment customers also allows firms to define a tailored collections strategy per group to reduce risk and improve customer relationships. Collection terms should be discussed and agreed from the very outset of a relationship and then applied consistently throughout. A disciplined and structured approach to collections again reduces DSO and improves cash flow, whilst at the same time nurturing a much closer customer relationship. Naturally, this also provides more scope for flexibility in the collections process if required.

Lastly, by combining multiple sources of external and internal credit information, it is possible to predict the bad debtor of tomorrow. Every customer should be evaluated regularly for risk and analysis of their payment history and behavior provides the key risk indicators. For example, if every complaint raised by a customer is spurious, this is a sure sign that something is wrong. Using historical data to analyse root causes for complaints allows a firm to both identify and counter illegitimate complaints at an earlier stage. More importantly, it allows a firm to modify internal processes and procedures. Long-term structured complaint analysis leads to improvements in logistics, services, and administrative processes. The result is fewer complaints, improved payment times and reduced write-offs.

A Transparent and Customer-centric Strategy

For many businesses, credit, complaints and collections management are still functions considered to be outside the focus of senior management. But at a time when there is much greater scrutiny of a firm’s A/R and its true value in respect of how much is actually tied up in high-risk customers, a good credit, collections and complaints policy is no longer a luxury and is certainly not a burden for companies looking to reduce the cost of their working capital. It is a valuable aspect of doing business that provides tangible financial and operational benefits.

It means that supplying the customer no longer ends when the product or service has been delivered. Rather, it means maintaining a 360? view of customer relationships, allowing businesses to benefit directly from the level and type of customer engagement these functions provide. A customer-intimate credit manager not only clears the path to payment and improves A/R, but can form the strongest of bonds by understanding and analySing customer behavioral information to ensure the relationship is sustained.

Elevating A/R to a strategic level also means that there is transparency throughout the company – from the collections department, through finance and account management, to the chief financial officer (CFO) and chief executive officer (CFO). This ensures that all business functions can apply a consistent approach to managing the customer relationship with the ability to identify early on exactly why payments are being delayed, and allow an informed and timely response in accordance with the customer’s profile.

Transparency is just as important externally, because lending by banks has fallen faster and further than ever before. Banks may still be happy to lend to a well-managed and growing business but they are not prepared to lend money simply to plug holes in a firm’s balance sheet. A much better way to balance the books, optimise working capital and boost profitability is in unlocking the funds tied up in A/R by adopting a strategic and customer-centric approach to credit, collections and complaints management.

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