Account Receivable management and operating cash flows need to be given priority
June 17, 2021

Most businesses have a common business challenge managing their account receivables as clients continue to drag their feet on timely payments. This is always a matter of great concern for each business stakeholder as cash flow duress is a significant business sustainability deterrent. However, depending on the industry, business and sector, cash flow aberration has its variants. Companies usually manage their cashflows in line with agreed tenor terms, but the issue comes in context to persistent overdue. Overdue beyond 120 days is a matter of worry, whilst anything over 150 days is by far a red flag as it can impact business stability. In the ordinary course, ageing may look normal compared to industry norms, but it should not be a subject of standardization and should be reviewed cautiously as per each business dynamics. Prudence demands that acceptable receivable ageing must consider the nature of business and industry norms, employed capital, working capital cycles, debt and P&L margins.

Company receivable position influences both its P&L and cash flows, so these cannot be separated. An average account receivable from a project has to factor in its working capital cost impacting its profitability which will be based on the company’s cost of finance and operations. The Contract Lead must know this factor at all times when factoring their net gross margins. Often company agrees to enter low-margin contracts with higher tenors resulting in a double whammy that erodes the net GP but not enough to provide for SG&A cost burden. Every business must be mindful of this aspect before agreeing on any deferred payment terms or allowing them to drag their receivable ageing.

Besides P&L, the Company management and finance must not lower the guard on timely collections. Even if contract margins are high, the negative cash flow must not interfere with the company operating cash flow. At times, the company’s working capital life cycle becomes negative due to the cumulative effect of its monthly cash expenses. Therefore, companies must not overwhelm themselves in stuck up and long overdue only but closely monitor their DSO days to avoid negative operating cash flows. Finance and CEO must remain vigilant of this aspect as an oversight on operating cash flows due to receivable or high overheads; the drain on cash flows can be disastrous. Therefore, there should be a clear demarcation between operating cash flows and cash flows impact from finance activities and investing activities. Ideally, companies should maintain a minimum of two months of their monthly expenses as free cash flow for cash expenses between salaries, vendor payments and overheads, including bank charges. These need not be tied to any debt or routine collections but be strictly part of free cash flows.

For planning the cash flows and for a smoother working capital life cycle’s management, primary and secondary cash needs should be classified. We term as primary and the essential business continuity needs as Delta one, usually salaries, taxes, utilities and minimum operational expenses. These should be met from free cash flows themselves without any option for deviations. On the other hand, the bank’s repayments, supplier obligations etc., from client receipts should be categorized in delta two. Any net residual flows should be directed towards maintaining the free cash flow threshold that is necessary and highlighted earlier.

The company can afford up to a certain extent to agree on allowing deferred terms if the debt burden is duly factored along with overheads in the net GP of the project, not otherwise. Business must also consider that the debt element must not be over 2.5 times of EBITDA subject to industry norms. Any debt must commensurate with the company’s overall financial situation, not just based on an individual project basis. At times, just one or few projects alone brings the company to its knees due to its negative working capital life cycle. This must be as per company capability, debt-equity ratio, and liquidity ratios. As a prudent measure, the company must decide its strategy in advance on risk parameters and client diversity mix. These are usually board-driven guidelines, but stakeholders need to remain vigilant of their business mix, even for partnerships and SMEs, and its critical financial do & don’ts. This essential financial discipline can save businesses. These often keep changing the goal post to manage their receivables instead of ensuring that free cash flows are enough to provide for the delta one payments at all times. Even in delta 2, they should adhere that bank repayments must be made in time as deferment may become a challenge to retain healthy banking relationships.

In the recent past, the criticality of stable cash flows has been on all businessmen’s minds. Its due importance is being rigorously tested. With many lessons learnt during the ongoing turmoil, everyone is prioritizing this. How best to manage this a vital enabler towards business resilience. There are no alternatives or shortcuts to lower your guard on efficient cash flow management with an eye on timely collection of your dues, no matter what business size, large or small. Prudence rules here as debt or capital alone cannot sustain business due to their inherent cost and limitations.

Businesses, therefore, need to plan, ensure adequate controls on their receivables and maintain free cashflows.

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