Amidst global uncertainty, PE mid-market companies are tapping into the least expensive source of cash to avoid rising interest rates.
With the latest announcements by the Fed regarding the expected interest rate increases during 2022, we can presume higher interest rates on nearly every type of variable consumer and business debt. With “cheap debt” options that were available over the past several years, many PE companies took the easier route of borrowing low-interest debt rather than focusing internally on aggressively generating positive cash flow.
Now, increasing inflation and borrowing costs are persuading those same Private Equity firms to reassess the cycle of borrowing on their Receivables to fund the shortfalls in cash flow. In particular, PE portfolio companies are recognizing the need to more effectively analyze and improve Trade Receivables performance to maximize cash flow generation.
“…inflation is leading to interest rate hikes that could weigh on valuations.” – Pitchbook
Many small and mid-market companies in the PE portfolio suffer from haphazard, inconsistent, and/or inefficient Receivables Management processes. This results in huge delays to cash flow, resulting in portfolio companies having to pay unnecessary borrowing costs and suffer needless bad debt expenses that reduce bottom lines.
How to evaluate Accounts Receivables performance in portfolio companies.
In evaluating whether your portfolio companies are maximizing cash flow from its Receivables, you should ask two questions:
- Are the Credit Departments in my portfolio companies effectively and efficiently managing the trade receivables asset?
- What resources are available to help us achieve the highest available cash flow from the Trade Receivables Asset?
Conducting a proper evaluation begins with five important steps.
- Hold your Accounts Receivables team accountable for accurate cash flow forecasts. Effectiveness in receivables management means cash is turning quickly. Is your credit manager providing accurate daily and weekly forecasts of incoming cash from customers? Do projected pay dates come and go with little explanation as to why forecasts were not met? Does the company rely on inaccurate reporting methods, such as simple DSO (with no adjustments for disputes and terms exceptions) or due dates? If any of these circumstances apply, you can be encouraged that these present real areas of opportunity to improve the accuracy of your forecasts and to become laser-focused on incoming cash.
- Measure what the team members accomplish. The sudden and explosive growth of teams working remotely has precipitated major challenges for companies. The most glaring of these challenges is the inability to track various receivables management activities. It’s usually not until expected customer payments are missed that companies realize there are problems. Inadequate follow-up, skills training, or lackluster performance by team members in accomplishing required tasks are always going to make cash flow suffer.
- Insist on reviewing process flows for each type of work performed in your A/R Department. It is extremely difficult to be certain that you are getting the most out of your resource investment until you can review well-constructed, easy-to-understand processes. These processes should show who is involved for specific tasks incorporated in each collection, credit, reporting, and dispute management process. If your Credit Manager has not designed these for the company, it is unlikely the inefficiencies have been squeezed out of your processes.
- Automate all manual processes. Do collectors still add notes in spreadsheets to track collection activity? Are analysts wasting time manually matching open items on a customer’s portal to a database or spreadsheet for statuses and pay dates? Are you manually billing invoices to customer portals or even now sending individual email invoices out? Automation should remove the need for most of these manual processes. If you do not already utilize bots, API, and/or computer programming scripts in your Receivables management process, you are probably wasting money on labor-intensive processes that should be automated. As a caution, do not proceed with automating until step #3 is complete. You will waste time and money trying to work around unproductive processes.
- Ensure priorities are correct. Is your portfolio’s A/R Department focused on confirming prompt payment on the largest items first to maximum cash flow? Is there robust, detailed reporting on the top 25 past due customers, allowing your credit department to focus their efforts on getting you paid? If you have collection software, it should be relatively easy to compile these details and have good insights on payment statuses. Good, reliable data will allow a credit department to quickly resolve disputes and confirm pay dates.S
Winning the Cash Flow battle starts with good data+automation.
How does a company ensure it is doing everything it can to tap this free cash flow hidden in its receivables? Successful companies measure and report on everything in their Trade Receivables Portfolio; every measurable, available data point gets measured.
Below are several examples of conditional logic and processes used by successful, high-performing credit departments to enhance A/R performance:
- When a customer misses its Thursday cash flow run, then the missed payment appears in Friday’s Cash Flow Exception Report.
- If a customer has 10 invoices missing from the customer portal billed 5 days ago, then the EDI Missing Invoice Report is routed to the EDI team immediately for resubmission.
- If a customer takes an extra 5% off all invoices in recent payments, then the Unauthorized Discount Report creates an automatic collect back notice to the customer.
Increasing borrowing costs for entities with effective Trade Receivables processes should not cause panic. If you lack confidence in your portfolio companies to have effective A/R processes in place, then following the steps outlined in this post can be a launchpad to accelerate your cash flow and reduce your borrowing costs. Portfolios and valuations can improve, even while the world continues to grapple with risks tied to ongoing uncertainties. Focusing your efforts on low-cost solutions that are ensuring your portfolio companies are maximizing cash flow in their Accounts Receivables will reap immediate and long-term benefits that can improve valuations in nearly any economic environment.
Pam Krank is the current President of The Credit Department (TCD). She regularly consults Private Equity and mid-market companies on effective risk management and improving cash flow. Her insights can be found across numerous industry publications on credit management and accounts receivables, including NACM, CFO.com, and others.
Read more on how TCD helps Private Equity and mid-market companies improve cash flow.