Optimizing Working Capital: Negotiating Agreements with Banks, Vendors, and Customers
Companies often require more working capital to finance their day-to-day operations as they grow. However, financial managers are constantly being asked to do more with less, making it important to track every payment, to know exactly what you owe, to whom, and when each payment is due. Understanding payment term opportunities can provide well-needed negotiation leverage, freeing up cash and aiding the budgeting process. This article’ll cover how payment terms can be part of your working capital optimization, including negotiating bank, vendor, and customer agreements.
Understanding Working Capital Optimization
Working capital is the money used in day-to-day trading operations in your business. Working capital optimization means optimizing the balance between assets and liabilities, and the effective management of cash flow in order to meet a company’s short-term operating costs and debt obligations. By optimizing working capital, an organization can streamline processes, increase flexibility in the market, and reduce reliance on external funding.
Negotiating Bank Agreements
Working capital can be significantly impacted by the terms of bank agreements. When negotiating agreements with banks, it is important to consider factors such as interest rates, payment terms, and collateral requirements. Considering these factors can help avoid cash flow hiccups and free up cash.
One way to optimize cash flow is to negotiate longer payment terms with banks. This can free up cash in the short term, allowing the organization to focus on core operational processes and strategic initiatives. Additionally, taking advantage of banks’ early payment discounts can provide further cost savings.
Negotiating Vendor Agreements
Vendor agreements are another key area for working capital optimization. Payment terms affect cash flow, profitability, sales growth, credit, and supply risk. Therefore, teams can evolve from a cost-saving function to a cash flow-generating function by better-managing payment arrangements with vendors.
The functions which will have the most effect on payment terms are Accounts Payable and Procurement. Together these functions must process and negotiate all trade receivables and trade payables, money owed, and money earned. Optimizing payment terms is the most direct way to increase working capital.
Negotiating longer payment terms with vendors can provide significant cost savings. However, ensuring that the organization is talking to the right person and that the offer is mutually beneficial is important. Additionally, harmonizing payment terms per vendor through renegotiation means cost savings, reduced administration time, and better supplier relationships.
Negotiating Customer Agreements
Customer agreements are also an important area for working capital optimization. Implementing shorter payment terms for customers can help reduce the working capital required to finance day-to-day operations. Additionally, creating incentives for early payments and applying invoice financing methods can provide further cost savings.
When negotiating customer agreements, it is important to consider the overall impact on cash flow. For example, while implementing shorter payment terms may reduce the amount of working capital required, it may also impact customer relationships and sales growth. Therefore, it is important to strike a balance between short-term cost savings and long-term growth.
Defining Net Working Capital
Before negotiating working capital targets and benchmarks, it is important that the buyers, sellers, and their advisors in a deal setting have a clear understanding of what will and won’t be included in net working capital for the purposes of closing the deal. In an M&A transaction, net working capital and net working capital targets are often defined terms in both the letter of intent and the purchase agreement.
Negotiating Net Working Capital Targets
The most practical and commonly used method of setting net working capital targets and benchmarks is to calculate a historical average amount of net working capital needed to fund a company’s operations. Calculating an average over a historical period removes any seasonality effects and reveals a “normalized” level of net working capital needed to support the company’s ongoing operations with no capital disruption.
While conducting due diligence, buyers may find potential adjustments to certain balance sheet items that comprise net working capital, which can affect the calculation of the net working capital target. Sellers will often make the argument that they have historically operated with excess working capital based on comparisons to industry averages. Buyers should always cautiously approach any “excess” adjustment of this type.
Optimizing working capital is crucial for any business’s profitability and smooth running. Negotiating agreements with banks, vendors, and customers can save significant costs and free up cash. Additionally, understanding net working capital targets and negotiating them effectively can directly impact the final purchase price of a transaction. By taking a strategic approach to working capital optimization, organizations can streamline processes, increase flexibility in the market, and reduce reliance on external funding.