• Importance of working capital
• Initiatives to improve working capital
• 1. Improve debtor collection to less than 45 Days
• 2. Work in progress/accrued income conversion to less than 30 Days
• 3. Extend payables - end of month 60 Days
• 4. Incentivise customers to pay in advance
• 5. Leverage government schemes for tax credit
• Summary

Importance of working capital

Managing working capital efficiently emerges as a crucial determinant of sustainable growth and success for B2B software companies. Working capital plays a pivotal role in ensuring the smooth operational continuity of B2B software companies. By optimising working capital, owner-managers can unlock avenues for value creation in the competitive B2B market it operates.

Let's delve into the importance of working capital with the help of numerical illustration.

Consider Cash-tight Software Ltd., a B2B software company with an annual turnover of £10M and a 25% EBITDA margin. The company currently has a working capital cycle of 90 days, with debtor collection days of 75 days, work-in-progress/accrued income conversion taking 45 days, and payables settled within 30 days. At this rate, it takes 90 days to convert income into cash. That is three months of working capital locked in and requires to be funded most likely by an interest-bearing revolver facility from the bank.

Should Cash-tight Software Ltd. aim to enhance its working capital efficiency, a reduction in the working capital cycle could substantially benefit the company's financial health. For example, by decreasing debtor collection days to 45 days, reducing work-in-progress/accrued income conversion to 30 days, and extending payables to 60 days, the company could potentially unlock an additional £1.85M in cash flow.

Initiatives to improve working capital

A prolonged working capital cycle often indicates underlying inefficiencies in business operations and cash management practices. A significant gap between the point when revenue is generated (recognised) and the actual collection of cash suggests areas for improvement. Over a period of time, a downward trend in the working capital cycle typically signals positive progress, indicating that the company is effectively managing its cash flow and reducing the time it takes to convert revenue into cash. Conversely, an upward movement in the working capital cycle suggests operational inefficiencies that need to be addressed.

Here are four ways you could improve your working capital and unlock cash and resulting operational efficiencies:

1. Improve debtor collection to less than 45 Days

You have to get your debtor collection in order. In our experience, 45 days is an ideal benchmark and it is possible to streamline your days of sales outstanding. Here are some practical ways to improve days of sales outstanding.

• Streamlining invoicing and collection processes:

This is getting the basics right and includes

1. Accurate and timely invoicing: Ensure invoices are generated promptly and contain all relevant details, including clearly defined payment terms.
2. Automated billing systems: Leverage automated billing software to eliminate manual errors and ensure invoices are sent out efficiently.
3. Establishing clear payment terms: Clearly outline the expected payment time frame and communicate these terms upfront to customers.
4. Regular cash (debtor) reconciliation: Conduct regular reconciliations to identify and address outstanding invoices promptly.
• Accelerating debtor payments with incentives:

Offering incentives for early payments can encourage customers to settle their invoices sooner, reducing debtor days. This could include:

1. Early payment discounts: Consider offering a small discount for customers who pay within a specified time frame.
2. Points or loyalty programs: Implement a points or loyalty system that rewards customers for timely payments.
• Factoring for efficient cash flow management:

You could approach financial institutions and request factoring services to accelerate cash flow and reduce dependency on debtor payments. Factoring involves selling unpaid invoices to a factoring company, which provides immediate payment to the business. The factoring company then collects the invoices from the customers and retains a percentage as a fee.

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For e.g., with one of our portfolio companies that serves customers including a large telecom major, we get paid in less than 45 days vs customer payment terms of 60 days because we leverage factoring. This is possible because the client is a large company with good creditworthiness. The interest rate on the factoring is based on the client’s credit rating so it worked very well overall.
• Automated reminder system for effective debtor management:

Implementing an automated reminder system can significantly reduce the likelihood of late payments. Consider a structured reminder sequence:

1. 14 days before due date: Send an email reminder to notify the customer of the upcoming payment due date.
2. Seven days before due date: Send another reminder email to reiterate the upcoming payment deadline.
3. On the due date: Send a final reminder email to encourage immediate payment.
4. Three days after the due date: Send an email reminder indicating that the invoice is past due.
5. Seven days after the due date: Send a final reminder email stating that further action may be taken if the payment is not received.

If this is all too elaborate you should target a minimum of three reminders - one 7 days before, one on due date and another either 3 or 5 days after due date. Note, this will only work if the cash (debtor) reconciliation is done regularly otherwise you will not be on top of the due dates in the first place.

• Understanding customer payment processes:

A thorough understanding of the customer's payment process is essential to streamlining collection efforts. Identify any peculiarities or unique payment requirements and ensure your systems align with these preferences. Some customers may prefer automated portals or direct debit arrangements, while others may prefer traditional invoice-based payments. This will help you avoid clerical errors that can sabotage your ability to collect on time.

• Addressing non-payment issues:

In some cases, customers may not adhere to payment terms despite reminders and incentives. Address these situations in one of the following ways to minimise the impact on cash flow:

1. Open communication: Engage in open and transparent communication with non-paying customers to understand the reason for delayed payments.
2. Payment plans: Offer payment plans or flexible payment terms to accommodate customers facing temporary financial challenges.
3. Legal action: If amicable resolutions are not feasible, consider pursuing legal action to recover outstanding debts.

2. Work in progress/accrued income conversion to less than 30 Days

• Effective project management:

In the case of project work that spans many months/years, effective project management plays a pivotal role in accelerating the conversion of unbilled work into cash. Here are some strategies to achieve this:

1. Establish clear project milestones: Break down large projects into manageable phases, each with defined completion dates. This provides a structured framework for tracking progress and ensuring timely invoicing.
2. Optimize resource allocation: Allocate resources efficiently across projects to ensure timely completion without overburdening teams. This helps maintain project momentum and reduce delays.
3. Implement timely invoicing: Generate invoices promptly upon reaching project milestones, ensuring that accrued income is recognised and reflected in the financial statements accurately.
• Preventing unnecessary work without PO or contract cover:

To avoid extending WIP timelines and increasing working capital requirements, adopt a stringent policy of not commencing work without a purchase order (PO) or a firm contract in place. This holds the customer accountable for the agreed-upon work and protects the company from potential non-payment or delays.

1. Require PO upfront: Before commencing any work, obtain a signed PO from the customer. This formalizes the contract and provides legal recourse in case of payment disputes. Once you start work it is difficult to pull back. If you do need to start work have an upfront contract where you agree with the customer by which date they will have a PO and without that, the work doesn’t move to stage two.
2. Set clear PO deadlines: Agree on a specific date by which the customer must issue a PO. If the PO is not received by the agreed-upon deadline, temporarily halt the project until the PO is secured.
3. Implement contractual clauses: Include clauses in the contract specifying that work will not proceed without a valid PO. This clearly outlines the company's position and protects its interests.

3. Extend payables - end of month 60 Days

• Negotiating extended payment terms:

Negotiating favourable payment terms with suppliers can provide valuable breathing space for cash flow management. While maintaining strong supplier relationships, explore the possibility of extending payment terms to 60 days from the standard end-of-month deadline. This additional 30 days can significantly reduce the company's working capital requirements, allowing for better utilisation of funds for growth initiatives.

• Thorough approval process for payments:

To ensure financial prudence, implement a rigorous payment approval process. Except for exceptional circumstances, all payments should undergo a thorough review to assess their validity and necessity. Direct debit arrangements should be avoided, as they bypass the approval process and can lead to misallocation of funds.

• Competitive procurement and negotiating favourable payment terms:

During the procurement process, conduct thorough market research and engage in competitive bidding to secure the most favourable pricing from suppliers. When selecting new suppliers, actively negotiate attractive payment terms to further reduce working capital requirements. Remember, every time the payment terms are changed, a clear justification should be provided to maintain transparency and accountability.

• Effective communication of payment terms:

Clear and consistent communication of payment terms to suppliers is essential for maintaining strong relationships and ensuring timely payments. Clearly outline the agreed-upon payment terms in contracts and purchase orders, ensuring that both parties are aware of the expectations. Regularly review and update payment terms as needed to reflect the company's financial situation and negotiate more favourable arrangements when possible.

4. Incentivise customers to pay in advance

Incentivising customers to make upfront payments can significantly improve a company's working capital by accelerating cash inflow. Offer customers discounts or trials or new solutions for payments in advance. This can encourage customers to commit to longer-term payments, boosting immediate cash inflow. In our experience, a good target is to get customers to pay six to twelve months in advance. Additionally, providing price stability by waiving inflation charges for multi-year contracts further enhances the appeal of prepayments, further strengthening the company's cash flow and financial stability.

5. Leverage government schemes for tax credit

This may not be applicable to all software companies but wherever applicable (e.g., in the UK), leverage government schemes such as R&D tax credits that enable companies to claim tax relief or cash credits for eligible expenditure, thereby enhancing available cash. With regards to R&D tax credits in the UK, you need to:

• Ensure that your company qualifies for the SME scheme
• Keep track of and prepare calculations of direct and indirect costs applicable to R&D
• Simply having all the data is not enough. You need to appoint a competent R&D services firm to manage the claim. R&D services firms typically allow you to pay on a contingency basis.

Summary

In conclusion, optimising working capital serves as a potent value-creation lever for small and medium software businesses. By judiciously implementing initiatives and being mindful of potential setbacks, owner-managers can drive enhanced financial performance, sustain growth, and fortify their position in the competitive software industry. Always consult with financial experts or professionals to tailor these strategies to your specific business needs and market dynamics, maximising the benefits while mitigating risks. Remember, prudent management of working capital is not just a financial strategy; it's a fundamental requirement for sustained success and innovation in the B2B software landscape.