Before attempting to apply for any various forms of financing, it is worthwhile to note several approaches for avoiding the need for financing. Is that possible? Yes. How? One of the best is the concept of zero working capital, which is a state in which the sum of a company’s investments in accounts receivable, inventory, and accounts payable nets out to zero. “But how?” you are asking, aren’t you?
This is made possible by using different management techniques for each of these elements of working capital:
The goal in managing accounts receivable is to shorten the time needed for customers to pay the company. This can be done through several approaches:
- One is to use a very aggressive collections team to contact customers about overdue payments and ensure that payments are made on time.
- Another approach is to tighten the credit granting process, so that potential customers with even slightly shaky credit histories are kept on a very short credit leash or granted no credit at all. A final approach is to drastically shorten the standard customer payment terms, which can even go so far as requiring cash payments in advance.
The goal in managing inventory is to reduce it to the bare minimum, which can be achieved in two ways:
- One is to outsource the entire production operation and have the production supplier drop ship deliveries directly to the company’s customers, so that the company never has to fund any inventory—the company never purchases raw materials or work-in-process. Instead, it pays the supplier when finished goods are delivered to its customers.
- A different approach is to use a manufacturing planning system, such as just-in-time (JIT). Under this concept, the inventory levels needed to maintain a proper flow of inventory are reduced to the bare minimum through a number of techniques, such as many small supplier deliveries straight to the production line, kanban cards to control the flow of parts, and building to specific customer orders.
The goal in managing accounts payable is to not pay suppliers for as long as possible:
- One way to do this is to stretch out payments, irrespective of whatever the supplier payment terms may be. However, this will rapidly irritate suppliers, who may cut off the credit of any company that consistently abuses its designated payment terms.
- A better approach is to formally negotiate longer payment terms with them, perhaps in exchange for slightly higher prices. For example: terms of 30 days at a price point of $1.00 per unit may be altered to terms of 60 days and a new price of $1.02 per unit, which covers the supplier’s cost of the money that has essentially been lent to the company. Although there is a cost associated with lengthening supplier terms, this may be a good deal for a company that has few other sources of funds.
Forcing longer payment terms on suppliers is much easier if a company knows that it comprises a large part of its suppliers’ sales, which gives it considerable negotiating power over them. The same situation exists with a company’s customers if it has a unique product or service that they cannot readily find elsewhere, so they must agree to abide by the short payment terms. If a company does not have these advantages, or if competitive pressures do not allow it to make use of them, the best option left is the reduction of inventory, since this is an internal issue that is not dependent on the vagaries of suppliers and customers.
Dell Computer Company has achieved a negative working capital position, which means it makes money from its working capital. It does this by keeping only a day or two of inventory on hand and by ordering more from suppliers only when it has specific orders in hand from customers. In addition, Dell pays its suppliers on longer terms than the terms it allows its customers, many of whom pay by credit card. The result is an enviable situation in which this rapidly growing company can not only ignore the cash demands that normally go along with growth, but actually take in cash from it.
Working capital is not the only drain on cash that a company will experience. It must also invest in fixed assets, such as office equipment for its staff, production machinery for the manufacturing operation, and warehouses and trucks for the logistics department. Although these may seem like unavoidable requirements that are an inherent part of doing business, there are a few ways to mitigate or even completely avoid these investments.
If a company adds branch offices or extra distribution warehouses, it must invest in fixed assets for each one. This is a particular concern when extra distribution warehouses are added, since a company must absorb not only the cost of the building but also the cost of the inventory inside it. A better approach for a cash-strapped company is to centralize virtually all operations, even if there is a cost associated with not decentralizing. For example: shifting to a central warehouse will eliminate the cost of a subsidiary warehouse, but will increase the cost of deliveries from the central warehouse, assuming that shipments must now travel a farther distance.
Rent Or Lease Facilities And Equipment
With so many leasing companies in the market today, as well as manufacturers financing the lease of their own equipment, a company has a wealth of financing choices that allow it to avoid the purchase of its facilities and equipment. These arrangements can be a straight rental, wherein the company has no ownership interest in the assets it uses (also very similar to an operating lease), or a capital lease, in which the terms of the lease agreement assume that the company will take possession of the asset being leased at the end of the payment term. In either of these cases, the total of the rental or lease payments will exceed the cost of the asset if a company chose to purchase the asset; this is due to the maintenance and interest costs of the lease supplier, as well as its profit. The main advantage is that there is no large lump-sum payment required at the time of asset acquisition.
Some portion of every department can be outsourced to a supplier. Although the main reasons for doing so are related more to strategic and operational issues, you can also make a strong case for outsourcing because it reduces the need for fixed assets. Here are why:
- By using outsourcing to avoid the hiring of clerical staff, a company no longer has to invest in the office space, furniture, or computer systems that they would otherwise require.
- Shifting the distribution function to a supplier can completely eliminate a company’s investment in trucking and warehouse equipment, whereas outsourcing production will eliminate the massive fixed asset investment that is common for most manufacturing facilities.
- Shifting a company’s computer operations to the data processing center of a supplier will eliminate its investment in its own data processing center, which may be considerable. By using outsourcing, a company avoids not only an initial investment in fixed assets but also the update and replacement of those same items.
If a company can enter into a partnership with another company, it may be possible to use the other company’s assets to transact business. For example: if a drug research company has a new drug to market, it should enter into a partnership with an established drug manufacturing firm, so that the research firm does not have to invest in its own production plant. This arrangement works well for both parties: The research company can avoid additional cash investments in fixed assets, while the other company can more fully utilize its existing assets.
If a company brings a particularly valuable patent or process to a partnership, it can use this to extract a large share of the forthcoming partnership profits, too.
This list includes many cases in which fixed assets could be eliminated, but at the cost of increased variable costs. Examples of this were heightened distribution costs in exchange for eliminating an outlying distribution warehouse, renting equipment rather than buying it, and outsourcing services rather than attempting to operate them in-house. These are acceptable approaches for many companies, and for several reasons:
- One is that avoiding the fixed costs associated with a fixed-asset purchase will keep a company’s total fixed costs lower than would otherwise be the case, which allows it to have a lower break-even point, so that it can still turn a profit if sales take a turn for the worse.
- Also, if there are few and meager funding sources, the added variable costs will not seem like much of a problem when weighed against the amount of cash that a company has just avoided investing in fixed assets.
- Finally, the centralization of operations and use of outsourcing will reduce the amount of management attention that would otherwise be wasted on the outlying locations that are now no longer there or the departments that have been shifted to a supplier. In smaller companies with a dearth of managers, this is a major advantage.
Consequently, the increased variable cost of some of the fixed-asset reduction options presented here should not be considered a significant reason for not implementing them.
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