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Fine-tuning the cash conversion cycle to optimize working capital.

Chief Financial Officers (CFOs) today face an economic landscape like no other. Unpredictable interest rates combined with a sustained labor shortage, supply chain challenges and high inflation have substantially increased the cost of doing business.

While CFOs and Treasurers have dealt with rising costs before, never have they had to navigate so many complex issues on the heels of a global pandemic. This has led many treasury and finance teams to reevaluate their approach to working capital and the cash conversion cycle (CCC). While each company addresses the challenge a little differently, based on their collection cycle and funding sources, all are zeroing in on the components of the CCC that most impact their access to working capital. These components include:

Days Sales Outstanding – DSO

Which measures the average number of days it takes to collect payment for a sale, is the first component of the CCC. There are several things that companies can do to reduce their DSO today and insulate it from unexpected expansion in the future.

Electronic receivables

Most organizations continue to rely on both checks and ACH credit for incoming payment transactions. The use of paper checks, in particular, is slowing the time it takes to receive funds. By digitizing more incoming payments, companies can reduce or eliminate the float associated with mailed payments. However, that frequently leads to the decoupling of payment dollars and payment data, which can increase processing float. When CFOs and Treasurers take a more wholistic view of the incoming payment process and look for ways to not only digitizing the payment, but also leverage AI to automate the cash application process, there is greater impact.

Improving customer credit risk management

When it comes to reducing DSO, companies often look first to digitizing incoming payments as mentioned above. However, they may discover additional benefits by implementing efficiencies further up the order-to-cash cycle. Companies that offer payment terms all have a process for determining the credit risk for new customers. For many, this is an inefficient and manual process. As a result, few companies have effective processes for monitoring customer credit quality over time.

By leveraging the technology offered by banks and fintechs, companies can automate the credit application and monitoring process, which results in a multitude of benefits including: a more seamless customer onboarding and buying experience, fewer manual processes that can slow the sales process and reduced risk for aging Accounts Receivable and credit loss — a risk that is top of mind for many CFOs in the current economic environment.

Collecting and using data

Everyone in the world of finance has a special place in their hearts for Excel. It is a fantastic tool. However, when it comes to automating financial data collection, running real-time scenario analysis and achieving forecast accuracy — without the fear of someone deleting or altering a formula — Excel falls short. A number of technologies and tools are now available that can not only help companies leverage their current financial data to make more informed financial decisions, but also predict changes in cashflows based on historical data.

Days Inventory Outstanding – DIO

The average number of days a company holds inventory before selling it, is a good measure of liquidity. It tells you how quickly a company turns inventory into cash, an indicator of its operational and financial efficiency. While supply chain challenges make headlines, there are a number of things CFOs should be considering when it comes to tightening DIO.

Tighter carrying cost management

When interest rates rise, carrying costs increase as well, which can impact key ratios, borrowing and covenants. Fortunately, data-driven forecasting tools are now available to companies that have historically relied on less-sophisticated methods. Some that have resisted investing in automation and electrification are now giving these tools a closer look.

Adjusting inventory methods

Faced with ongoing supply chain challenges, some companies are finding that their current inventory methods no longer meet their needs. For example, a Just-in-Time approach may need to be replaced with another alternative if a company cannot procure products fast enough to meet demand. A first-in, first-out method that expenses oldest costs first while more recent costs remain on the balance sheet, can overstate gross margin and understate costs, especially during periods of high inflation.

Days Payable Outstanding – DPO

Refers to the number of days it takes a company to pay an invoice. The greater the DPO, the longer a company can retain available funds, thus reducing borrowing costs or, alternatively, increase interest income. Here is how some are changing their approach to optimize their DPO.

Extending DPO, when practical

Many treasury teams live by the phrase “cash is king.” How a company manages cash is highly contingent upon which side of the equation they are on — paying or receiving. When seeking to maximize working capital by extending DPO, particularly in the current economic environment, it is important to be mindful of DPO’s impact on supplier relationships. More than ever, we see many companies tailoring their payment approach to the needs of individual suppliers.

Digitizing payments, when possible

Companies continue to move to electronic payment systems to increase card payments and reduce the number of paper checks they process. Because companies remain mindful of individual supplier needs and preferences, these are not one-size-fits-all solutions. Many of the companies we work with are seeking flexible payment solutions that respect the preferences of their trusted partners.

Re-evaluating payment terms

Given the rising cost of doing business, some companies are taking a fresh look at the early payment discounts and other payment terms offered by their vendors and suppliers. For the first time, some are choosing to accelerate payments and take advantage of other terms that shore up profit margins and make good business sense. Similarly, some are reconsidering the payment terms they extend to customers. If cash flow is tight, some are considering adding discounts for speedy payment or discontinuing terms that are no longer in their best interest.

The bottom line:

CFOs don’t have crystal balls. They can’t predict the future. But optimizing their cash conversion cycles to free up and more effectively deploy working capital may be the next best thing.

CFOs need not undertake the optimization process alone. Banks like ours conduct payment cycle reviews and map plans for optimizing the cash conversion cycle, start to finish, at no cost. Implementation can take place over time.

We live in unprecedented times. Closer attention to the cash conversion cycle will help companies get through them.

About the author:
Jessica Segebarth, CTP is a vice president and Treasury Management Officer for Commerce Bank in Dallas, TX.

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