Companies with razor thin profit margins are easily
impacted by fluctuations in their cost of capital. It certainly makes sense:
Small changes in interest rates can have a damaging effect on a company’s
ability to generate profit. These issues are further exacerbated by long
receivables collection times, ones where customers extend their payment terms
and credit by delaying payments. However, for companies with large receivables
and payables, the advantages available to them should never be ignored. In
fact, they amount to using the value of both to bring down financing and
increase profit.
The Value of the $1.00 Profit Rule
Whenever I start with a new customer, I always begin by asking them how much it takes in sales to generate a single dollar of profit. In fact, just this past weekend I asked the very same question of a friend of mine, one who had started a business over a year ago and one that was having some difficulty dealing with small profit margins. At first he was unsure of the answer, but gradually he stated that it took about $6.00 of sales to generate $1.00 of profit. He then asked why this was so important. My response was simple: Every dollar reduced in financing is the same as generating $6.00 of sales; it’s a 600% return on investment, and this alone makes it the most important reason companies with razor thin profit margins should focus on reducing their financing.
Now, reducing your financing doesn’t happen overnight. There is no all-encompassing solution, or single magic bullet that will immediately produce results and reduce your costs of capital. Instead, success is predicated on taking a series of small steps, ones that help reduce your financing across your entire enterprise. In this case, it’s never just about demanding a lower interest rate on financing. While this does help, it does nothing to address other aspects of your operations where financing may be eroding your profit.
Going back to the discussion I had with my friend at the wedding, I made it a point to ask him what he thought distributors and value-added resellers (VARS) do with their inventory counts on finished goods. For instance, would they hold onto inventory indefinitely for a customer, or would their holding costs be so high that they would have no choice but to sell that inventory the first chance they got? Obviously, no company that operates with low margins can hold inventory indefinitely. It simply isn’t feasible. Inventory is but one area where your company can have a direct impact on its costs of financing. However, there are others.
The above video is from the post: Calculating the Daily Cost of Money and Gross Profit for the Small Business Owner
1. Inventory Financing
When you think of financing inventory, think of an unpaid balance on a bank loan, a credit line, or a credit card. Every day you don’t clear that balance is yet another day you have to cover your cost of capital. It’s no different with inventory. Every day you hold finished goods in your warehouse is another day you have to cover a cost of financing. In essence, you can’t pay for that inventory until you’ve sold it to a customer and been paid for that purchase.
Now, every company would love to increase their inventory turnover rates to the point where they can match their payables to their receivables. Unfortunately, it simply isn’t possible to have a situation where the products you receive today, are immediately sold tomorrow. However, that doesn’t mean you can’t incentivize your customers to purchase more frequently, or incentivize them to make purchases that they otherwise wouldn't make. As such, here are some simple approaches that can help you get your inventory turnover rates up.
- Inventory Liquidation: Ever notice how quickly retail outlets sell clothing once it passes a certain season. That’s because if they don’t sell those products, their holding costs will erode their profit until all that’s left are losses. This is the most important part of managing your inventory. When you encounter slow moving inventory, sell it immediately. The faster you sell your inventory, the less impactful your carrying costs and the better your profit on sales. Use pricing and invoice discounts to move product.
- Compensation Plans: The surest way to keep your inventory moving is to make sure that you’ve successfully accounted for that inventory with contractual supply agreements with customers. In this case, it’s about using your contracts with customers so that your inventory is already spoken for. This means using compensation and reward programs that give customers a reason to return to your business. After all, your customer base is what makes your inventory turnover rates increase. This means you must have compensation plans that reward customers for business.
The above table is taken from the post: A Reward Program That Lowers Customer Acquisition Costs & Increases Customer Retention
- Measuring Holding Costs Versus Higher Volume Purchases: I’ve covered this on several occasions. Every company must measure its holding costs of inventory versus the savings that come from lowering pricing and freight with larger volume purchases. This means tracking your sales closing rates and defining your costs to hold product before making those sales.
- Product Grading Systems: The best run inventories only put products on their shelves if they have multiple customers. In this case, they never hold product for a customer indefinitely – unless they have a solid contract that stipulates carrying charges. Your company should only put products on the shelves if you have multiple customers willing to purchase that inventory. This will help reduce obsolescence and help you increase inventory turnover rates.
2. Receivables Factoring
Your financing doesn’t end once you’ve shipped and invoiced your customer; your financing costs only end when you’ve been paid by your customer. In this case, you have to cover a financing cost with inventory and a financing cost on your receivables. This is why companies must do what they can to reduce their receivable financing charges. Success means you’ll improve cash flow and increase profit. So what are some of the ways you can reduce these costs?
- Alternative Financing: Don’t shy away from alternative financing. There are some fantastic solutions available for companies that need to combine their existing financing with additional sources. Receivables factoring may be a little more expensive than bank financing, but it allows you to avoid long receivable collection times. It’s also a financing solution that allows you to pursue any opportunity, regardless of its size. The best part of receivables factoring is that it acts as a loan, but won’t be represented as such on your balance sheet. It's also ideal for companies with poor credit ratings as the finance company bases its decision to advance funds on the account debtor's credit history. This means the financing company reviews your customer's credit history - not yours. Purchase order financing is another source of credit, one that allows you to use your purchase orders as collateral.
The above table shows how you can compare financing costs on bank financing versus factoring by customer account: Sample Receivable Factoring Excel Sheet: Effective Rates & Interest Rates
- Prepayment Discounts: Give your customers a reason to pay early. The earlier they pay, the lower your financing. Net-10 days 1% invoice discount is an acceptable incentive for customers. However, make sure the percentage discount on the invoice doesn’t erode your profit margins. If you can’t afford to give more than a 1% discount, then don’t.
- Prepayment Discount: Another solution is to reduce your pricing - provided your customer prepays their entire order upfront. To incentivize your customers, take your daily cost of capital (daily interest rate) and multiply it by the average days on receivables collection for this specific customer’s account. Next, split this amount and give your customer half as a discount on their order. For example, let’s assume your company averages 45 days on receivables collection with a given customer. It costs you an average of $45.00 to finance one of these receivables. Therefore, give your customer a price reduction on their purchase of $22.50. They save money, while you save $22.50 in financing. Now, some might assume this solution is too easy, and it is. In fact, it’s so successful that I make sure all my customers use this strategy whenever possible. Why does it work? Simply put, customers tend to take the savings upfront, rather than think about how much they save by delaying their invoice payments.
- Use Your Volumes: I’m amazed at the number of times I come across companies that fail to use their volumes of scale to their advantage. Worse yet, they assume that these volumes only extend to their purchases on materials and finished goods. However, a company’s volumes also extend to its borrowing of money. What’s required is the willingness on your part to define just how much business your bank gets from your enterprise. Define this business and use it to negotiate more favorable terms and interest rates. Next, shop these rates around to other banks. You need to use your economies of scale across your entire enterprise – that includes using the amount of business you give your bank to your advantage.
3. Leasing Large Capital Expenditures
The decision to make an outright purchase on a capital expenditure, versus capitalizing the asset and depreciating it year-after-year, ultimately comes down to time. If the purchase can be done within a period of one year, then it can be done with cash. However, anything past a year should be leased. Leasing allows you to reduce your profit on paper by using the depreciation on the capital purchase to lower your overall tax burden. The graph below illustrates a standard straight line depreciation on a capital expenditure.
The above table is from the post: Fixed Asset Management: Straight Line Depreciation on Capital Expenditures
In fact, leasing is almost always preferred to making purchases with cash. That’s because leasing helps improve cash flow, and a strong cash position will always help your company reduce financing. For instance, a strong cash position allows you to reduce purchasing costs with vendors and creditors by getting early payment and prepayment discounts.
Your company can lease all of its equipment and machinery. It’s a solution companies use to lease everything from office furniture to large expenditures on equipment and machinery. Most importantly, it allows your company to keep up with the latest product offering. With technology changing day-to-day, it just makes sense not to tie your company down with only one solution.
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