Balance Sheet Optimization: It’s a Virtuous Circle
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In the day-to-day rush of managing business operations and maintaining minimum liquidity, many companies neglect to take a step back and review whether they are borrowing more than necessary — or paying more than they need to for their credit facilities. By seeking out opportunities to optimize borrowing, you can achieve balance sheet optimization, which effectively boosts your profitability by minimizing your interest expenses and maximizing your interest and investment income. Fortunately, all that’s required (at least initially) is a fresh look at your cash and inventory management processes. Doing so will ensure you’re on the right path.
Working capital, or the difference between your short-term assets and your short-term liabilities, lies in the center of that path. When this number becomes negative, you have to borrow to close the gap — unless you’re willing to sell assets or raise more equity capital. This isn’t a problem unless you borrow more money than you need, which is where balance sheet optimization comes in.
Here’s a classic opportunity in which you should be looking to optimize your borrowing needs: You’re giving customers better payment terms than your suppliers are giving you. Suppose the principal supplier of raw materials for your finished product has put you on a net 30 schedule, and you’re giving customers 60 days. Or perhaps your primary “raw material” is your employees, who expect to receive their paychecks promptly — regardless of your customers’ payment timetable. Bingo: You’re in the lending business.
In order to truly optimize your balance sheet, you need to look at your profitability in terms of the funds you’re both lending and borrowing. Have you taken a step back to ascertain whether you are borrowing more than you need? Ask yourself the following, if not:
- Are you satisfied with your company’s profitability?
- Do you always have plenty of cash on hand to meet your operational needs?
- If you do need to borrow, are you confident you’re getting a competitive rate?
If you answered ‘no’ to any of the above, it’s time to take action. Here are a few areas to optimize that can have a big impact on improving your profitability.
Rethink Payment Terms
First, tackle any payment term issues by negotiating better agreements with your suppliers. If you have a solid payment track record, you should be able to get a better deal with one of your current supplier’s competitors. As a best practice, you should review your supplier agreements annually and assess how any changes in your business might call for modifications or allow for more favorable terms. Arm yourself with competitive quotes to get the most out of your negotiations. Similarly, you should tighten up your customers’ payment terms. To do so, first determine the cost (in interest expense and/or the opportunity cost of having less cash available to use) of relaxed customer payment terms. That number will inform what kind of concessions — discounted pricing, for example — you can afford to offer your customers in exchange for more prompt payment.
Modernize Receivables and Payables
One way to accelerate receivables is to require payment by credit card. Even with interchange fees, you can come out ahead. Using a card to pay your bills also gives you the benefit of a lag between the date your customer is paid and when you surrender cash.
Setting up an automated payment system isn’t as tricky or costly as it may seem. There are a variety of third-party solutions available that will provide your team with the support you need to get these services up and running. Down the line, modernizing your receivables and payables will pay off; you will be able to better track these finances, ensure a consistent cashflow, take advantage of savings accrued by removing the paper element and provide better service overall. Furthermore, by integrating the payment system into your general ledger package, you will also reduce the administrative burden to your team, enabling them to focus on other, more strategic tasks.
Improve Inventory Management
You can also achieve balance sheet optimization through precision inventory management. Sitting on excess inventory comes with a high cost: You’re wasting space and valuable capital that you could be investing somewhere else. Depending on environmental conditions, this inventory could also degrade over time. By employing a “just-in-time supply management” strategy — in which you produce and deliver products just in time for them to be sold — you will cut costs and reduce waste. Though this is not a new concept, it has yet to be fully exploited by many companies.
Leverage Cash Management Tools
When big dollars are involved and card services aren’t an option, you can tap your bank’s cash management tools that allow you to accelerate payments into your bank account and postpone your outgoing bill payments until the last minute. For example, if you use a bank lockbox service, checks from your customers will flow to a special bank-managed post office box that is emptied several times a day. These checks will be deposited into your account and promptly credited. Your bank’s data systems will integrate with your own bookkeeping and treasury systems, keeping you up to date on the state of your payments. Accelerated payment services offered by banks also let you pay exactly when you want, allowing you to use your cash until the last minute, and thereby reducing your borrowing needs.
A “virtuous circle” will kick in as you begin to make progress with payment terms, processes and inventory management: The stronger your balance sheet, the better a credit risk you become to your bank. This in turn allows the bank to lend working capital to you at lower rates, which boosts your profits. Overall, an optimized balance sheet begets a stronger P&L, which is a win for everyone involved.
Don’t wait! Learn more on how to optimize your balance sheet today.