Accounting, Financial, Taxation

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:

Accounts Receivable

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:

1. One is to use a very aggressive collections team to contact customers about overdue payments and ensure that payments are made on time.
2. 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.

Inventory

The goal in managing inventory is to reduce it to the bare minimum, which can be achieved in two ways:

1. 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.
2. 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.

Accounts Payable

The goal in managing accounts payable is to not pay suppliers for as long as possible:

1. 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.
2. 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.

Centralize Operations

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.

Outsource Operations

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:

1. 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.
2. 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.
3. 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.

Use Partnerships

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:

1. 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.
2. 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.
3. 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.

Liabilities and stockholders’ equity support a company’s investment in assets. Liabilities must be recognized on the date they were incurred. Liabilities, much like assets, can be classified according to when they will be satisfied. “Current or short-term liabilities” are obligations that will be satisfied in the upcoming year; “Non-current liabilities” will be settled at some point beyond the current period. In general, balance sheet reports a number of current liabilities:

1. Accounts payable
2. Accrued salaries payable and related expenses
3. Sales taxes payable
4. Other accrued expenses
5. Income taxes payable
6. Current installments of long-term debt

Now, let’s go into the details….

Accounts Payable

“Accounts payable“, also known as “trade accounts payable“, represent amounts owed to other companies as a result of goods, services, materials, supplies, and so on acquired throughout the year. Conventional payment terms might require satisfaction of these obligations within 30 to 90 days of the invoice date, depending company’s relationship with the vendor.

Accrued Salaries Payable And Related Expenses

The recognition of accrued salaries and related expenses results from the application of accrual basis accounting. “Accrual accounting” requires revenues to be recognized when earned and expenses when incurred. The actual receipt of or payment with cash is not essential to the recognition of revenues and expenses in the accounting records. The key issue is whether product sales have occurred and what costs or expenses relate to the sale. Salaries are accrued because they are an expense that relates to the generation of revenue in the current period.

When an accrual takes place, it is often related to a transaction that does not coincide with the close of the fiscal year or the exact amount is not yet known (in the case of a contingent liability). For example: Royal Bali Cemerlang may distribute compensation to a certain group of employees on a weekly basis and others twice a month, on the 10th and 25th. Because the distribution of wage does not cover services provided by employees through the close of the fiscal year, an accrued liability for wages earned between the last payment date and the end of the year must be reported in the balance sheet.

The amount reported on the accrued salaries payable would also include payroll taxes that the company is responsible for and would include. This amount was computed at the close of the business year and recorded via a “year-end adjusting entry“.

Sales Taxes Payable

National & local tax authority mandates require corporations to collect sales tax when sales of tangible personal property are executed. Upon receipt from its customers, corporations have a legal obligation to remit these taxes to an appropriate government agency. Sales taxes are remitted periodically (usualy on monthly basis); therefore, any amounts collected represent a liability for the company collecting them.

Sales Tax Payable is classified as a current liability because satisfaction of this obligation will take place in the following month or quarter the longest.

Other Accrued Expenses

Other accrued expenses can include a variety of obligations. For example: this may include interest accrued on the company’s notes payable. Because the interest payment date does not fall at the end of the company’s fiscal year, there must be an accrual of interest from the last interest payment date through the end of the fiscal year. The company has additional obligations in the form of leases and installment notes that would require similar accounting accruals.

Accrued expenses can also include estimated liabilities that will be settled in the upcoming year. This could include: property tax expense that has been assessed for the current year but will be paid in the upcoming year, a litigation loss that has been accrued for but not yet settled, or bonuses that have been earned by key executives but will be paid in the upcoming quarter. Revenues received in advance (unearned revenue), such as deposits for goods ordered by the company, would also be recognized as a current liability.

Income Taxes Payable

Income taxes payable represents an estimated liability that is generally satisfied with periodic payments by the corporation to several taxing authorities. Income tax payments are based on an estimate of corporate pre-tax income. As estimates change with the passage of time, so will the periodic installments paid by the firm. Any estimated liability should be reported at the close of the fiscal year.

To understand what constitutes “pre-tax income (income tax installment)“, one must first understand the difference between before tax financial reported income (income statement) and pre-tax income (tax return). Revenues and expenses for tax purposes are determined in accordance with the rules set forth by the tax authority.

Revenues and expenses for financial reporting purposes are based on generally accepted accounting principles (GAAP). The result can be a significantly different income measure depending on which set of rules is applied. Because of this, companies generally report future tax liabilities and/or assets. Any income tax obligation (benefit) due in the following year is reported as a current liability (asset).

Current Installments Of Long-Term Debt

The final item shown under current liabilities involves components of long-term debt that are due in the upcoming period. This is typically referred to as the current maturities of long-term debt and may include obligations such as installment notes, mortgages, leases, and bond issues.

Upon review of a company’s financial statements, we may notice it has issued “commercial paper” that bears a certain average interest. Commercial paper generally represents short-term debt.

Read also part of this “Classification and Element Of Balance Sheet” post series are:

You must ensure that a well-managed accounts payable system is in operation. Any warning signs of problems with payables must be identified and solved. The control of the cash that leaves the company is as important as controlling the cash that comes in. To achieve control, payables must be aggressively managed in accordance with the company’s financial position and goals. Payment of bills must not be simply made but planned. Above all, payables must be viewed as a flexible system that you can manipulate in response to other factors such as sales decreases or slowdowns in collections.

Account Payable Control System

A well-managed accounts payable system should:

Evaluate Cash Flow - Every accounts payable strategy should be rooted in the realities of the company’s cash flow status. For example, if it takes 90 days to collect from customers, it is financially self-destructive to pay bills within 45 days. How long does it take dollars spent to be replaced? You should monitor the cash-to-cash cycle representing the length of time elapsing from the expenditure of dollars on inventory to the receipt of cash from sales. Take, for instance, a retailer who buys a product on January 1 and pays for it on January 30; it takes the retailer 60 days from that point to sell that product (which brings the retailer to March 31) and 45 days after that to collect the cash (May 15). The cash-to-cash cycle adds up to 105 days, which is the length of time the retailer is behind after expending the cash.

Set goals - Once cash flow has been appraised, establish written payment goals so there can be no confusion among bill payers. Avoid a situation in which staff makes the decisions about which bills are to be paid and when—usually suppliers who complain the most are paid first, regardless of overall benefit to the business. The payment of bills should be timed to coordinate exactly with formal disbursement goals. This means checks should be dated no earlier than the dates upon which payments are due (and suppliers should receive checks no more than a day or two earlier than the due date). The goal should be to hold cash in interest-bearing accounts until the last possible minute in which payments must be made and still maintain good relations with suppliers.

Establish payment priorities - It is advisable to establish a two-tiered list of payment priorities, which then becomes part of the formal payment strategy. Tier one, the group that should be paid at all costs and at whatever terms have been agreed upon, should include major vendors and service suppliers, bankers, and the government tax authorities. Tier two, which offers more room for short-term maneuvering during cash flow crunches, should consist of minor suppliers whose goodwill is less vital to the overall well-being of the company. Payment priorities should be in writing.

Aggressively negotiate payment - Granted, there is not much room for negotiation with bankers or tax collectors, but once they are taken care of, everything else on the payables front is open for discussion. You have leverage to negotiate better-than-usual terms from major suppliers, especially during recessionary times, when vendors are afraid of losing business. Determine the optimal payment terms (using the cash-to-cash or other cash flow information as a guide) then when orders are placed, not when bills become due or overdue, negotiate to achieve those terms.

Forecast cash needs - You should predict how much cash is needed—and when—to fulfill the payables obligations. That forecast becomes an important tool in averting cash flow problems. Will funds be available at the right time from bank accounts or bank credit lines? If funds will not be available, take precautionary measures such as stepping up customer collection efforts.

Keep good payables records - Payable records include weekly updates about the aging of every outstanding bill; documentation that matches each bill paid with its original sales order, delivery records, and payment invoice; and total cost records, including interest penalties paid on each bill. The last is important because it may not be evident how much it adds to the cost of doing business when the company winds up having to pay interest charges to finance late payables. Review payables records regularly. Payables reports are as important as other cash flow documents and must be evaluated. Review payables—aging schedules—weekly; cost records can be appraised monthly.

Recognize warning signs - Since cash flow cycles vary, there may be periods when payables get stretched without any long-term risk. But it is essential to spot indications of more serious problems. One approach is to draw up a ‘‘payables problems’’ checklist, which breaks down average bill age, promptness of tax payments, any interest charges and other warning factors.

Paying the right amount - Payments should be made in accordance with purchase order terms and discounts taken where allowed. Payments should only be made against the original invoice to prevent a duplicate payment against a photocopy or summary statement. Match all vendor invoices against receiving reports and purchase orders.

Considerations To Take In Managing Payables

Sound management of accounts payables takes into account the following:

Prioritize - Financial obligations fall into three categories: the bills to be paid as soon as they are due (wages and salaries, bank loans, and taxes), bills to be paid within 15 days (to important contractors for services already performed), and bills you try to pay within 30 days (all others). As your business begins to feel the recessionary pinch, try to stretch that third category out longer. In looking at cash flow, accounts payable are something that you have some control over—and suppliers can be ‘‘played with’’ if needed.

Negotiate - Negotiate longer payment terms in advance, although the process can be time consuming. Contact major vendors to ask when they absolutely have to have their money. This information should then get recorded in each vendor’s accounts payable file. It sets the guidelines for payment of all major outstanding obligations. With smaller suppliers, however, there may not be much potential payoff from stretching out payments.

Monitor payables closely - Each week analyze an accounts payable aging schedule along with other cash flow documents. As a last resort, the company should use its credit line to make payments if cash collections from customers are behind schedule.

Demonstrate good faith - When money does not come in, the company is in a jam. One possible solution: Pay only absolute essentials, such as salaries, rent, taxes, and loans. These expenditures cannot be delayed. Suppliers are more tolerant and flexible since they need the business. However, try to pay more to the demanding vendors and less to those more likely to wait. A partial payment shows vendors that the company is trying to pay them. Do not just send the money—get on the phone and explain what is happening and why and set up an informal payment schedule. Let the vendors know when they can expect to receive the balance due. A follow-up letter should confirm the telephone conversation.

3 Typical Symptoms Of Account Payable Problems

Some typical symptoms of accounts payable problems are:

Aged payables - Chances are that the company is heading for trouble when bills start becoming, on average, 45 to 60 days past due. (The only exception: bills whose issuers have approved late payment terms without interest penalties, at the time of order).

Interest penalties - Do not box yourself in by paying interest charges on overdue bills—unless there are clear financial benefits from using funds elsewhere. Once the company is paying penalties to even a few vendors on a regular monthly basis, it is in trouble. Instead, approach creditors with a workout plan that will reduce or perhaps eliminate interest charges.

Hassles from creditors - Make it a habit to communicate informally with creditors whenever there is a developing cash crunch. Creditors are typically understanding if the company has good intentions and is honest.

Information You Should Obtain From Vendors

Money can be saved by getting to know the policies of vendors and suppliers. Probe them for the best prices and terms. Ask open-ended questions, such as ‘‘What else can you do for me?’’ Ask vendors to complete an information sheet that forces them to write down the terms and conditions of their sales plans. With this form, their verbal promises become written ones. A list of useful information follows:

[-]. Vendor’s name, address, and phone number (will the vendor accept collect calls? Is there an 800 number?)
[-]. Sales representative’s name, phone number, and qualifications
[-]. Amount of minimum purchase
[-]. Quantity discounts available
[-]. Advertising/promotion allowances
[-]. Availability of extended payment terms
[-]. Financing charge on overdue accounts
[-]. Delivery terms
[-]. Service policies
[-]. Return privileges for damaged goods (who pays the freight?)
[-]. Credit terms (how flexible is it?)