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|
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