A “Win-Win” for Big Businesses and Small Supplier

Large corporations often call the shots when dealing with small suppliers in a competitive, uncertain marketplace. In fact, a recent study by the Georgia Tech Financial Analysis Lab reports that the average days in payables among public companies skyrocketed from 35 days in March 2009 to 46 days today. The White House reports that it’s common for some large corporations to delay payments for as long as two months nowadays.

For big businesses, however, joining SupplierPay is more than a smart public relations move. When a cash-poor small business has limited access to capital, management may seek alternative forms of financing – such as mezzanine debt or receivables factoring – that incur higher rates than large companies customarily pay on their credit lines.

Many of these incremental costs are passed down the supply chain to customers. If alternate financing doesn’t pan out, the small business may unexpectedly file for bankruptcy, leaving its customers to scramble for alternate suppliers. So, from the perspective of large corporations, SupplierPay may be seen as responsible supply-chain management. It infuses small suppliers with working capital, enabling them to invest in new opportunities, equipment and hiring. It also adds stability to the supply chain.

While small companies interpret SupplierPay as a step in the right direction, many remain skeptical. The corporations that sign-on promise – but don’t guarantee – faster payment and more favorable terms. If economic conditions deteriorate, will large corporations renege on their promises? Moreover, the new program doesn’t specify a timeframe for paying suppliers (unlike QuickPay) or define what constitutes a “small” supplier.

Take Matters into Your Own Hands

In addition to doing business with companies on the SupplierPay list (see the right-hand box), suppliers can proactively manage working capital themselves. One metric that many small businesses use to enhance working capital management is the “cash gap.” It’s based on the following easy-to-understand formula:

Cash Gap equals average days in receivables plus average days in inventory minus average Days in Payables

To illustrate how the cash gap works, suppose a company receives payments in 46 days (based on the average days it takes public companies to pay suppliers in the Georgia Tech study). On average, its inventory turns in 64 days and payables are paid within 20 days. In this example, the cash gap would be 90 days (46 days in receivables plus 64 days in inventory minus 20 days in payables).

Now assume the company’s annual cost of sales is $36.5 million. A 90-day cash gap means that the company is constantly fronting about $9 million in costs ($36.5 million divided by 365 days times 90 days). If the annual percentage rate on its line of credit is 5 percent, a 90-day cash gap will cost about $450,000 in interest expense annually (ignoring the tax benefit). If management can reduce the cash gap by 10 days, it will save the company $50,000 in interest expense each year.

Tips for Narrowing the Cash Gap

Here are three strategies to help narrow your company’s cash gap:

1. Collect money faster from customers. Send invoices faster, hire collections personnel, and review credit policies. Sometimes, it costs less to offer discounted terms for early payment than fronting the costs yourself. Perform credit checks on all new customers and collect interest on late payments.
2. Operate with lean inventories. Avoid advanced purchases and excessive stock levels. High inventory not only consumes working capital, but it also requires extra warehouse space and risks breakage, theft and obsolescence. Periodically count your inventory, noting slow-moving and excessive stock. Consider returning stale items for credit, trading them with a competitor or selling them at a discount.
3. Extend payment terms with your own suppliers. Many small businesses know first-hand how painful it can be waiting for collections, so they pay their own suppliers as soon as they receive bills. However, payables are a form of interest-free financing. Delay payments until they’re due – without compromising your relationships with suppliers by making them wait too long.

Creative Alternatives

A creative strategy for lowering cash outflows – which is unrelated to the cash gap equation – is offering non-cash incentives to managers and executives. For example, rather than offer a cash bonus at year-end, you could offer employee stock options to reduce the strain on operating cash flow.

You might consider a more radical idea – raise prices. Based on the law of supply and demand, price increases reduce demand. However, that might be a smart decision, if you’re currently growing faster than you can keep up. You’ll make fewer sales with higher prices, but you’ll also earn a higher margin on each sale, which could make up for the reduced sales volume.

Formulating Your Plan

If you’re currently experiencing a cash crisis, contact your CPA for advice on how to devise and implement short-and long-term solutions. SupplierPay may be a good start to improving access to affordable, consistent working capital for small businesses – and the SBA plans to recruit additional corporations to join the program in the future. But proactive small businesses should leave nothing to chance. Take steps to reduce your cash gap today.