Raising money by better Inventory management

Efficient management of Inventory (aka ‘Stock’) levels can free up working capital and is an important area where a manufacturing or trading business can raise capital from itself by being more operationally efficient. Note that whereas all businesses have debtors and creditors, most but not all businesses carry Inventory. This week’s article is for those that do so it won’t directly apply to many service businesses.

To help understand the detail of Inventory, it’s worth revisiting the cash conversion cycle: a manufacturing business buys raw materials which it then improves using the production process until they are ready for sale. During this time the Inventory (if correctly recorded) would move through the categories of ‘raw materials’, to ‘work in progress’ and finally ‘finished goods’. A trading business typically buys finished goods from someone else, holds these as stock and tries to sell them as quickly as possible. Either way, the core point is that as long as the firm has items that it cannot (because they are unfinished or obsolete) or has not yet sold, it has cash tied up. The idea then is to reduce inventory to an optimal level where we have enough finished product to meet market demand, enough raw materials to feed into the production process to keep the productive machine working, yet no more than we actually need because otherwise we are locking up cash flow unnecessarily.

The one situation most firms fear more than most is a ‘stock out’. This means that a customer needs an item but the firm doesn’t have any in stock and can’t supply it at that time. The immediate effect of this is that the business loses the sale and the associate profit and cash flows that go with it. The longer-term effects may mean that the customer switches to another supplier and the firm then loses that customer permanently, a move that destroys value in the firm. This is real danger that most firms will go to great lengths to avoid, so the level of stock kept for any particular item is based on demand forecasting, plus some safety margin. If you think about it, you are trying to trade-off the optimal level of working capital management vs. the potential loss of the lifetime value of a customer. The systems that are employed to forecast optimal stock levels become very complex for large companies with many product lines.

The other core idea around Inventory management is the idea of how perishable the goods are that the firm sells. The obvious example is a fresh-produce supplier: crops must be picked, sorted, packed and shipped to their markets very quickly. Crops that sit on the shelves too long literally wilt or rot away and their value becomes negative (there are clean-up and other costs related to expired stock). A less obvious example is a hotel or Bed and Breakfast: here each bed-night that isn’t sold can never be sold again – in other words the stock expires daily and is perfectly perishable. Seats on a plane or bus expire similarly with each trip where they are unsold.

Inventory is crucial to examine in detail when buying (or investing in) a business: a detailed look at inventory can paint a clear picture of which product lines are selling and which aren’t. If you find inventory that is not selling (typically picked up by an age-analysis of each product line, or inventory item) then you’ll want to explore whether the sales forecasts for those products are reasonable. You may even get to the point where you exclude any anticipated revenue from them from your cash flows and bring the valuation of the business down accordingly. For this reason you’d normally want to appoint a qualified valuation professional who has experience in that particular industry to work out the market (as opposed to book) value of the stock. Note too that stock is not always included in the purchase price for a business, so this gives some wiggle-room when negotiation.

So how much cash can we free up from inventory management? The answer is that it depends on the industry as different types of businesses have different patterns of inventory holding, so you’ll need to know how you’re doing relative to your peers and benchmarking is very important. The metric to use is how many inventory turns your business does each year. The formula is simple: sales/inventory (typically measured using annual numbers).

Using the demonstration business on ValuationUp.com, we can illustrate how a business can free up cash and increase its valuation by improving its inventory turnover. We’ll call the starting point ‘Old Sloppy’ with Inventory of 4,200 and annual sales of 30,000 which gives an inventory turnover of 7.14x per year. This is way lower than the industry benchmark (75th percentile for the Specialist Machine fitting industry) of 206x per year that suggests some serious problems in the business (and a large potential improvement to be made). The ‘Tight Ship’ scenario shows how improving inventory turnover to 25x per year frees up cash and increases valuation:

  Inventory turnover Free Cash Flow Y1 DCF valuation
Old sloppy 7.14x 3774 30705
Tight Ship 25x 8060 34789
Improvement 17.86x 4286 4084

What lessons can we learn from how big companies manage this? Vehicle manufacturers like VW use sophisticated electronic systems to predict the optimal level of stock in each dealership based on historical and predicted sales, plus the predicated ages of each of the used-cars serviced by each dealership and the related spares they expect to be needed. They also design the floor plans of their cars to be shared across different models, for example the Golf and the Audi 3 share many similar components that not only cut down on design and manufacturing costs, but also allow for lower stock holdings across the group. This frees up cash and lets them do more with their balance sheet.

For the smaller business, the first step is measuring and reporting on your inventory turnover each month, then doing so by product line. Any old inventory should be written off or disposed of. Then as your business grows you need to put in some simple systems to help manage your inventory. Remember that if you’re buying a business a close look at its inventory levels will tell you a lot more about the business than you can expect from the seller :)

Freeing up cash by paying suppliers later

There’s an old saying that if you want to make money you should ‘buy low and sell high’ and another that says you should ‘buy now and pay later’. These two are very connected in that if you sell something to someone on credit you will try to recover this cost (time value of money plus default risk) by increasing the price they pay.

Whereas last week we looked at how a business can raise cash from itself by improving its operational performance in the field of Accounts Receivable (debtors), today we’ll look at the other side of the coin – creditors (Accounts payable). Remember that since you’re hopefully selling for a lot more than your input costs, managing Accounts receivable is potentially far more impactful (since the sums involved are larger) than managing your Accounts payable, so start there. With accounts payable the broad theory is that if you can push the credit terms you receive from your suppliers out a bit, you can improve your cash flows and hence your valuation.

Let’s recap the working capital cycle (I’ll use a manufacturing business as an example): the business buys raw material from a supplier (either on cash or account), which it then puts through a production process where it transforms various raw materials into a new product. During this process the materials are now reflected as stock – work in progress. The finished product is then added to your stock holding and remains there until it is sold. The eventual sale can happen on a cash or account basis. Throughout this cycle cash is locked up: from the time you pay for the raw material until the time that your customer pays you for the finished product. Until the money is in the bank, it’s uncertain and prone to risk. More importantly, until you’ve been paid for the product you sold, there is no cash to resume the cycle and buy the next load of raw materials. The trick is to get your clients to pay you for the finished product before you pay your suppliers for the raw material. Tight Accounts receivable/debtors management will bring the payment your receive forward. Clever Creditors/Accounts Payable management will delay the payment you make for the raw materials. Together, these effects are powerful.

The typical measure by which we measure the amount of cash locked up in creditors is ‘Creditors days’. The formula is simple: Creditors days = Accounts Payable/Cost of sales*365 (This formula is also known as ‘Days Payable Outstanding’).

Let’s have a look at the effects: To do this, I’ll use the demo business on ValuationUP.com and look at how flexing creditors affects Free Cash Flow in year 1, and thus valuation. We’ll call the starting point ‘Old Sloppy’ with Creditors days of 28 and annual sales of 30,000, and the ‘Tight Ship’ scenario shows how much Free Cash flow is generated by stretching creditors terms to nearly 60 days, with a similar improvement to valuation:

  Creditors days Free Cash Flow Y1 DCF valuation
Old sloppy 28 3352 20285
Tight Ship 58 4910 21905
Improvement 30 days 1558 1620

Pushing payment terms out from 28 days to 58 days frees up cash and increases valuation, providing your clients don’t penalise you for the delay in payment. There are very few situations where your purchase terms don’t include penalties for late payment, or incentives for early payment. This is a trade-off you’ll have to make.

Just as for Debtors days, the ideal or acceptable level will vary for each industry and will depend on how much power you have over your suppliers, so benchmarking is really the only way you’ll know if you’re doing well or not. Keep in mind that if you’re buying everything on credit, you can be certain you’re paying a higher margin for it. The optimisation you have to think of is whether the terms of the ‘loan’ you are getting from your suppliers are better or worse than your cost of capital. Ideally, you want your suppliers to give you a much lower effective interest rate, so you need to know your cost of capital and start there.

Managing this effectively means that you need to measure your creditors days and report on them at least monthly. You should also be doing this for each supplier, so that you have a clear idea of where you can stretch terms on a client-by-client basis. Note that if you start to defer payments to existing customers you can expect some loud feedback – the smart ones will quickly pick this up and find out why you’re doing this. Expect a lot of loud squealing as you push payment out – but be aware that unless you have a lot of power over your suppliers that you’ll find they quickly adjust via other means. In other words, there are levels here where your suppliers will still be happy and your business isn’t at risk. The trick is to gradually find the optimal level and no more.

Lastly, bear in mind that just you defer payment terms to suppliers, so their debtors management efforts will ramp up. You may want to refer back to last week’s article to understand things from their side :)

Raising money by managing Accounts Receivable/Debtors

Better management of your Accounts receivable (debtors) frees up cash from your working capital cycle and increases the value of your business. In other words, it’s worth doing. The problem with most growing businesses is that they start off desperate for sales, then desperate to produce what customers have ordered, and before they get around to the invoicing side they’re off selling again. Invoicing seems almost like a chore compared to the hunt for a new sale, so the invoice is sent a few days late…and then since we’re so busy selling or producing we don’t chase the payment. Over time and with the continued pressures of launching our business, a few days becomes a week, a week becomes a month and suddenly we have a healthy 5 year-old business except that our clients paying us on 60 days.

Let’s think about what that means: we’re waiting 60 days to get the money clients owe us for something they’re already benefiting from. Providing we’ve done our pricing right, the money clients pay us includes coverage for all costs of the production and distribution process, plus coverage for all overheads and our own financing costs, plus our profit margin. In other words, it’s far more important to manage the people who owe you money rather than the people you owe money to!  (Trade creditors typically reflect only input costs, so they’re often only a fraction of the value of your debtors – this is obviously very industry dependent since in high-volume retail the difference between cost and sales price can be only a few %).

Another way to think about this is that Accounts Receivable is the business extending an interest free loan to its clients. Think about this for a while: why do your clients deserve a loan from you? Is your business a bank? What does it tell you about the ‘credit-worthiness’ of your clients if they can’t repay your loan?

The typical measure by which we measure the amount of cash locked up in debtors is ‘Debtors days’. The formula is really simple: Debtors days = Debtors/Sales*365

The level will vary for each industry and will depend on how much power you have over your customers, so benchmarking is really the only way you’ll know if you’re doing well or not. What one tends to find is that businesses that have high levels of Debtors compensate by charging high margins: the margin covers the cost of financing the clients paying on 60 days and also those who never pay. In theory, if you know your cost of capital you’ll be able to structure your debtors (and your creditor) terms in such a way that they give you a better return than your cost of capital.

Let’s have a look at the effects: To do this, I’ll use the demo business on ValuationUP.com and look at how flexing debtors changes Free Cash Flow in year 1, and thus valuation. We’ll call the starting point ‘Old Sloppy’ with Debtors days of 75 and annual sales of 30,000, and the ‘Tight Ship’ scenario shows how much Free Cash flow is generated by improving debtors, with a similar improvement to valuation:

  Debtors days Free Cash Flow Y1 DCF valuation
Old sloppy 75 4910 37044
Tight Ship 30 8829 41869
Improvement 45 days 3919 4825

The next question is how to do manage your debtors more effectively? The first steps are that you need to measure your debtors days and report on them at least monthly. You should also be doing this for each client, so that you have a clear idea of which clients are paying you late (a debtors age analysis). Secondly have a good look at the terms you offer your customers – while competitive pressures will probably dictate them to some degree (again, benchmarking will help) you can do a lot to incentivise earlier payment through offering trade-credit on their next purchases through you. What you really are wanting to achieve is that your debtors pay you before they pay other suppliers, and the only way you’ll do that consistently is to make it worth their while (and to make sure they know its worth their while). Lastly, make sure that you have someone whose bonus depends on getting your debtors days right and make sure they are managed and measured to achieve this. It has to be someone’s specific responsibility, preferably someone used to sucking blood out of a stone!

It’s worthwhile to note that managing debtors (aka collecting money) can be challenging. There are a number of large companies who buy debtors books from other businesses at a discount, and then try to extract as much money from that book as possible. There techniques are specialist and advanced, but in broad terms they follow the legal process (along with legal threats), they use statistical techniques to score each debtor and understand what will work best to get money from them, the process is measured in detail and managed daily, and lastly that each person involved is incentivised to achieve. If they can do it, so you can you.

Raising money, from yourself

Raising capital is something almost every business goes through at some stage: applicable to start-ups and companies of all sizes all the way through to large listed companies. The process of raising capital is very complex, sometimes tedious, legally detailed, and generally long – a typical funding round takes over 9 months to complete. There’s a lot to comply with and consensus needs to be reached amongst several stakeholders with different interests at heart. It’s not cheap either – advisory fees on big deals (R100M and above) can easily add 2-3% on the deal. More shocking is that for smaller rounds typical of the SMB market (say under R1M) the total cost of raising the money can be as much as 25% of the money raised! In many cases all of these efforts meet with rejection and all of that effort goes wasted.

So sure there’s a better, easier, more efficient way to raise money?

The good news is that for established firms there is: in the next few articles we’re going to discuss how established businesses could raise money from themselves, primarily through operational improvements. The lessons here don’t directly apply to start-ups, although start-ups will do well to remember that running a tight ship will allow them to grow faster with less capital too. There’s another great spin-off from running your operations well: lenders and investors take great confidence in a well-run business and perceive it as lower risk, so not only is one able to raise the money more easily but often it comes at a lower cost too.

Here are the three key areas we need to focus on:

–       Profitability: if your product is being correctly priced, your cost of sales managed tightly, and if your operational expenses are kept as lean as possible then you’ll have a few more % of your total sales to flow into your bank account. If you’re not doing this then you are simply giving away money to your customers, staff or suppliers along the way.

–       Productivity: The people and the assets you employ need to be as productive as possible. If you are getting the most from your production, sales and administrative staff then you’ll be able to do more with a lower wages bill. Likewise, if you’re proactively maintaining your capital equipment to keep it productive over the long-term and if you’re making sure machines run round the clock, then you’ll be spending less money on capital equipment over the long-term and will have a more profitable business that generates more cash too.

–       Working capital management: A tightly managed business optimises its Accounts Receivable (debtors), Inventory (stock) turnover, and Accounts Payable (creditors). A surprising amount of cash can be locked into the working capital cycle of any business and if the net amount is negative, then growing the business will drain cash that in turn will put the business at risk if the growth rate is too fast. Managing each of these in turn will allow your business to run as cash-positively as possible meaning that any cash injected from a capital raise will immediately be used more productively and with substantially lower risk.

These three areas are typically expressed as ratios, with the underlying data supplied from your latest financial statements (we’ll discuss which ratios apply in each of the subsequent articles). Assuming we’ve done the analysis of our business already, how do we know if our performance isn’t already very good (or very bad)? For some ratios (typically your liquidity ratios) there are absolute levels which any firm should avoid. For the ratios we’re talking about in this analysis almost everything depends on the industry you’re in. That means that you need to know how you’re doing compared to your industry peers, which in turn means you need to do some benchmarking – something most small businesses are very bad at.

While I will discuss various benchmarking options further down the line, your accountant or industry body will probably be able to give you rough guidelines. Step 1 is still do the analysis of your own ratios. Then objectively and deeply question how you can improve profitability, productivity and your working capital cycle. Benchmarks will guide you as to how well you are actually performing, but there is still a lot you can do without them.

Next week we’ll start to look in more detail at each of the 3 key areas we need to focus on, with example illustrated by real-life numbers. For a business trying to raise capital, you’ll be surprised at what’s possible with less effort and in a shorter time than chatting to your bank.