3 Ways Manufacturing Companies Can Improve Cash Flow
By Andrew Frazier, MBA, CFA
Cash flow is a challenge for most businesses, especially manufacturing companies because they tend to have more areas to manage.
Beyond just sales and cost of sales, there are several other factors that can have a significant impact on their cash flow. This difference is exacerbated during periods of growth since manufacturing companies tend to grow faster and have a longer cash conversion cycle. Fortunately, they have several tools for improving cash flow. The top 3 are:
- Proactive Accounts Management
- Inventory Optimization
- Capital Spending Plan
Accounts Receivable (AR) is selling products and services on credit – effectively an interest-free loan to customers, while Accounts Payable (AP) is purchasing inventory and supplies on credit – effectively an interest-free loan from suppliers. Both an increase in the AR balance or a decrease in the AP balance will cause a corresponding decrease in available cash. Therefore, it is important to actively work to minimize AR and maximize AP without being late on payments. Although manufacturers cannot dictate terms to larger customers, they can offer discounts for early payment and actively collect upon outstanding balances to encourage them to pay faster. On the flip side, requesting credit and negotiating the best terms possible from suppliers helps to finance the cost of inventory rather than drawing upon cash reserves.
1. Accounts Management
I worked with a manufacturing company experiencing cash flow challenges during a slow period and the owner had to loan money to the business. They also used AP to finance some of the shortfall which resulted in overdue bills and threats of being cut off by suppliers. Proactively communicating with suppliers and managing their expectations resulted in temporarily extending credit terms and maintaining access to raw materials. After obtaining financing the company experienced several months of growth which was great (sort of). Growing required increasing inventory and operating expenses that must be paid with cash prior to the cash from additional sales being received so they were “Making Money But, Running Out of Cash.” They continue to utilize the strategies outlined in this article to proactively manage cash flow.
2. Inventory Optimization
Most manufacturing companies have a significant amount of cash tied up in inventory. Therefore, it is critical that inventory levels are optimized to ensure enough is available to satisfy customer needs and operate efficiently. This is even more important when the inventory turnover rate is low, there are long production processing times, or there are many different products that are not manufactured on a regular schedule.
One business I helped was profitable and the owner didn’t understand why the profits were not reflected in the company’s cash balances, especially since they had to pay taxes on them with cash. By reviewing financial statements, we found that the company’s inventory levels were growing faster than its sales. Upon further inspection, it was learned that employees were ordering more materials than needed for an order to take advantage of discounts. However, many times they would just order more the next time without checking to see if there was inventory in stock. There were several items he had enough inventory to last 2+ years. All that money was tied up in inventory on hand which could have been used for growing the business, paying taxes, and/or personal enjoyment. My client established new purchasing procedures and an approval process with oversight to avoid this problem in the future. Unfortunately, he still has more than $500k of his personal cash tied up in excess inventory. Ouch!
3. Capital Spending Plan
Manufacturing companies tend to make significant investments in equipment and other assets without a full understanding of the impact it will have on cash flow. Even when financing the purchase there are ancillary expenses and cash needs that are generally not accounted for in advance. Initially, they may be delivery, installation, permits, inspections, and materials not covered by financing coming out of business cash flow. The purchase may also require additional investment in labor, inventory, and repair parts that will also come out of operating cash flow. Plus, there is a financing cash flow impact both upon purchase and associated with ongoing payments on debt.
One of my clients financed the purchase of a $200k machine for his business with 85% equipment financing ($170k) so he only needed to pay $30k in cash. However, the installation took longer and was much more expensive than expected. Plus, there were significant delays associated with the permitting, obtaining licenses, and utility upgrades that were unexpected. Combining that with rent, staffing, and initial inventory resulted in the entire project costing $500k so his cash flow hit unexpectedly ended up being $300k higher than expected. Whoa!
Effective cash flow management and planning are important for all businesses, but even more so because manufacturing companies tend to be capital intensive, require significant amounts of inventory, and they generally invoice customers with terms rather than being paid at the time of sale. As a result, active strategies to minimize AR, maximize AP, optimize inventory, plan for major expenses, and maintain sufficient cash reserves are critical.
Andrew Frazier, MBA, CFA is President and COO of A&J Management and a NJMEP Resource.
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