Article: Always short of cash?

I found a good article for people that are always short of cash.  It is an article by Henry Ong.  
If you experience cash shortages even if your business is booming, it’s time to tweak your accounts payables management
By Henry Ong

Have you ever wondered why you sometimes experience cash shortages even if your business is booming? No matter how much money your business generates, perhaps you always feel that you are always short of cash every time your suppliers are knocking on your door. The cause of the problem may be poor accounts payable management. When managing cash flows, therefore, you should remember that timing your accounts payable payments is as crucial as collecting your accounts receivables.

You can manage your accounts payable by stretching out the payment terms as long as possible without damaging your credit standing to suppliers. There are some business owners who pay their payables too early simply because they have so much cash in the bank, but they don’t know that they lose the opportunity to earn extra interest income on their cash. On the other hand, there are entrepreneurs who pay their suppliers too late and end up being slapped with penalties and charges. It is thus important that you manage your payables to the best interest of both parties.

As a guide, you can determine your days payable outstanding by first computing your payable turnover. For example, assume that your accounts payable at the start of the month was P150,000 and that during the month, you made total merchandise purchases of P250,000. After one month of operation, you found out that the balance of your accounts payable by month’s end was P100,000. To compute for the payable turnover, divide your total purchases of P250,000 by the average accounts payable of P125,000; this will give you a ratio of 2.0x. This ratio simply tells you that you pay for your purchases two times a month. To get the number of days payable outstanding, divide 30 days by the ratio 2.0 to get the average of 15 days.

What this means is that on the average, it takes about 15 days for you to pay your suppliers. With this information on hand, you can now check how many days it takes you to sell your inventory and collect all your receivables. Ideally, the total number of days of inventory and receivables should not exceed your days payable outstanding; this way, you would receive all cash collections just in time when you are about to pay your suppliers. In this example, let us say you can convert all your inventories into cash in 12 days. This would mean that on the 12th day, you would already have the available cash to pay your suppliers and enjoy three more days before your accounts payable becomes due. You can then take advantage of this by depositing the cash in an interest-bearing bank account.

If business is slowing down and you are finding it difficult to unload your inventory and to collect from your customers, you may consider stretching out your credit terms with suppliers. From the same example, if the number of days to convert your inventory to cash is rising to 18 days from 12 days, you may need to negotiate your credit terms with your suppliers, for instance by having them extended by at least three more days up to 18 days to protect your cash position.

Sometimes, so you will be encouraged to pay early rather than on the due date, suppliers may offer you a trade discount like, say, a 2 percent discount if you pay within 10 days for an account payable due in 30 days yet. In general, trade discounts are good because it allows you to take advantage of it to lower your purchase costs. But there are times when trade discounts are not favorable. How would you know if it is good or not? You can do this by computing the effective interest cost assuming that you are going to borrow the money to pay your account in 30 days. You then should compare this to the prevailing borrowing rate from the bank. The formula for effective interest cost is EAI = (discount / 100 percent - discount) x (365 / payment period – discount period).

Suppose the prevailing borrowing rate is 16 percent per annum and you are offered a 2 percent discount if you pay in 10 days an account that is otherwise payable in 30 days. Using the above formula, we will find that the effective annualized interest cost is 37 percent as compared to only 16 percent, so it is wise to take advantage of the discount. If you have negotiated your credit terms to 60 days, your effective interest cost would be 14.9 percent, lower than the prevailing bank rate of 16 percent. In this case, you can afford not to take the 2 percent discount because it is cheaper to stretch out your payment.

It is perfectly all right for you to control the terms of accounts payable so it is to your advantage. Perhaps, it will be helpful if you can put a monitoring system where you can sort all accounts payable that will soon be due; this way, you will know just how much cash you will need to prepare to pay your suppliers on time.

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