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A thought-leadership piece by Dr Andrea Moro, Cranfield University and Channel Senior Advisor/Scientific Board

January 2020

Firms typically do not go bankrupt because they are making losses: firms go bankrupt because they run out of cash. In addition, firms run out of cash because they fail to adequately plan their short-term funding needs.

The cyclicality of firm cashflows – inbound and outbound

Interestingly enough, firms tend to be quite cyclical in their cash outflows and inflows.  Outflows are often more certain; they tend to be clustered at the end or beginning of the month when salaries are due and supplier invoices are to be paid. On the other hand, cash inflows are more challenging to predict and may be linked to the customer type. If the firm is a B2B, inflows happen at the beginning of the month when invoices are due; however if the firm is a B2C, the cash inflows are likely to be spread throughout the month (e.g. cloth retailers tend to experience an increase of sales – and the related cash inflow – the week after salaries are paid). Thus, cash collections may make the firm more cash rich at certain points on a cyclical basis. To recap, there is always some degree of uncertainty about the future cash inflows (customers can be delinquent or even do not pay at all if they go bankrupt) while there is a certainty about cash outflows.

Cashflow levels can thus be estimated – somewhat

The cyclicality of the cash flows on monthly bases facilitates a clear “theoretical” net cash flow estimation, not only for the next months but, assuming that there are no major changes, for longer periods. At the same time, it is important to stress that the net cash flow estimation is an estimate in the sense that there is no absolute certainty about the future cash inflows.

However, firms can discriminate between the “good customers” that is those that paid regularly in the past and there is no reason to think they will start to miss future payments, and those that are “bad customers” that is those that tend to fall behind in their payments. The capability to discriminate the customers turns to be very important not only in terms of customer management (the latter type of customers have to be properly monitored) but also in terms of how to “use” the related debtors to finance the working capital. In fact, good customers provide the firm with high-quality short-term assets (issued invoices and the related credit). These high-quality short-term assets may be freed up and turned into cash today with working capital programs.

For example, performing invoices can be sold to bank and increasingly non-bank finance firms and Fintechs so that the firm can access the cash immediately instead of waiting for the traditional cash conversion period of 60 or 90 days. By converting to cash today, funds can deploy to develop the business and pursue profitable new business activities, potentially leading to improved performance.

Second order benefits of working capital programs leading to performance gains

Interestingly, working capital programs may have additional second order performance-related benefits, sometimes linked to improved invoice data management and reporting that comes hand-in-hand with such programs. Increasingly, working capital firms (such as Channel and others) offer valuable software to its clients to facilitate the receivables financing, leading to improved data capture, monitoring and overall governance. Specific examples are provided below.

First, financing the invoices via working capital programs can lead to better data governance and thus improved alignment to better quality clients, leading to more revenue and quality revenue. Fintechs and non-bank specialty working capital players in particular have led the way to improved data management and reporting of the receivables book, helping businesses of all sizes better observe these trends. Poor paying clients, as observed in the data or advised by the financing or insuring partner, which are likely to not pay or dispute payments, are also more easily identified leading to more robust credit terms or exited if warranted.

Second, improved receivables portfolio data and analytics can be very helpful when the firm is facing a large customer order and needs to consider pricing discounts and delivery schedules. If the firm knows that the customer pays regularly with its improved data knowledge, the confidence of being able to finance the receivables at an attractive rate may drive the firm’s capability to secure orders from good customer.

Third, better quality customers can be offered extended time periods to pay the invoices since such extended credit will not affect the cash position of the firm. This is a persuasive tool used in customer sales negotiations and can lead to improved overall performance. In other words, the firm may cash-in immediately by financing invoices, irrespective of the extra time granted. Needless to say, that from the commercial point of view, the possibility to grant extra time to pay invoices can be a winning point.

Fourth, and remaining with the above example, by granting extra time to its customer, the firm implicitly signals high trust in its customer that can be reciprocated via a long-lasting relationship leading to preferred supplier status.  Essentially, working capital financing and receivables financing can be a tool that facilitates the strengthening of the relationship with the customer.

Fifth, the sale of invoices reduces the amount of less liquid short-term assets (debtors) and increase the amount of the most liquid short-term asset (cash in the bank). In other words, the figures in the balance sheet show that the firm is in a stronger financial position. This can be helpful when the firm approach a bank or any financial institution in order to secure other, long-term loans in terms of credit availability and credit pricing, again leading to improved firm performance.

Conclusion – Converting illiquid short-term assets to cash

In conclusion, it is very important for firms of all sizes to effectively manage their working capital needs. The possibility to efficiently finance their working capital requirements (so that the related cash flow can be put to productive uses immediately) allows the firm to exploit this illiquid asset and convert it to cash. This in turn leads to improvements in the commercial relationship (strengthening the bond with customers), simplifying administration, improving its financial position and thus leading to improved performance.

Working capital financing programs goes well beyond improving financial management since it has positive strategic implications and can help firm’s growth. However, in order to make this work, firms have to be very selective with its choice of partner!

Dr Andrea Moro is a senior advisor and a member of our Scientific Board, focusing on SME and corporate risk measures. He is a member of the faculty at Cranfield School of Management. Andrea has published over 30 journal and practitioner articles on SME/small business finance, entrepreneurs and credit risk subjects in leading journals, including the Journal of Banking & Finance as well as The European Accounting Review.  Before pursuing his academic pursuits, Andrea worked for 15 years as a senior financial advisor to SMEs, including financial planning, financial budgeting and cashflow management. Andrea also advises other start-ups in the Blockchain and Tech sectors.