(This story originally appeared in New Jersey Business Magazine.)

By David P. DeMuth

Manufacturers understand the critical importance of cash flows and margins.

Yet, the majority of business owners don’t do enough to protect working capital, which is the combination of accounts receivable, accounts payable and inventory.

According to a Crowe Horwath LLP study, 82% of U.S. manufacturing and distribution companies believe optimizing working capital is “extremely important” or “very important” to their company’s success. But only 46% say they had implemented a working capital plan. Another 7% of respondents say they have no intention of creating a plan to improve their operating cash flow.

“In practice, it can be difficult to manage working capital,” said CFO Consulting Partners Gary Cardamone, a director in the firm’s Manufacturing and Distribution practice. “Business owners and their staffs have long standing relationships with customers and suppliers. It’s a lack of experience, rigor and discipline while balancing key business relationships.”

For example, if a customer has 45-day payment terms, yet they don’t pay for 60 days, a manufacturer could potentially accept the past due payments because they’ve been a customer for 10 years. Why? Because it’s the way it has been done for a long time (i.e. the relationship). It often works the same way with vendors. Manufacturers have the right to negotiate payment beyond 45 days, but too many times they won’t because they’ve been supplying the business for years.

“You’re not going to disrupt that relationship,” said Cardamone who has helped countless manufacturers improve their financials. “Sometimes, business owners don’t want to affect those relationships. There is the relationship side and the business side. Sometimes, it’s about making sound business decisions to improve cash flows while working together with your customer or vendor.”

Here are six more ways manufacturers can find improve operating cash flow and net income:

1. Use 80/20 Rule on Inventory.

The Pareto Principle, also known as the 80/20 rule, is a time-tested observation that contains a general truth—80% of outputs come from 20% of inputs.

When applied to inventory, this notion can generate more positive cash flows and higher margins. How? After reviewing the numbers, business owners will learn that 80% of their turnover comes from 20% of the SKUs. In other words, 80% of the remaining SKUs could be tying up capital for an inordinate amount of time. Let’s face it: time is money.

CFO Consulting Partners’ Jeffrey Appleman, who is a director in the firm’s Manufacturing, Distribution and Business Services practice, said manufacturers need to invest their inventory dollars in the data, not anecdotal feedback from a limited number of customers.

“Manufacturers need to rationalize their SKUs,” Appleman said. “Regarding their inventory, management probably never focuses on the financial data. Business owners listen to the customers, but sales don’t follow. Meanwhile, the company is too heavily loaded with SKUs that turn infrequently. They keep large volumes of inventory to meet customer needs, but they are not rooted in reality. As a result, they have tied up a lot of cash.”

2. Project Positive Cash Flows.

Manufacturers should build financial models to ensure that their business won’t go upside down during sweeping changes in the economy.

With supply chain issues and rapid inflation that could cause short-term concerns about rising wages, manufacturers must price in front of the cost curve to improve their margins. If a financial analysis reveals a strong possibility that raw materials are projected to rise 5% and wages may jump 4%, then manufacturers may have to implement a 6% price increase to protect or improve margins.

“I’m not talking like a banker,” Cardamone said, “I’m talking like a manufacturer. Raw materials and labor are their direct variable costs. They need to price out in front of inflation on costs to protect their profitability. Margins speak directly to cash flow.”

3. Be Firm About Terms.

There is a very important reason why manufacturers create terms for their customers. A process is what separates a profitable factory from the rest. Terms are a big part of the process, which can feel more like a house of cards when the terms are ignored.

In other words, if customers have 45 days to pay, then that needs to be enforced. Seriously.

“Most companies don’t have enough discipline in the accounts receivable area,” Appleman said. “They let customers go over the agreed upon terms. It will take rigor and discipline. This will increase cash flow. If a customer is given 45 days to pay and they take 90 days, that’s a big difference.”

On a separate but related note, manufacturers must make sure they accounts payable terms match their accounts receivable terms. Otherwise, it will create a serious mismatch and negative cash flow.

“It’s why companies run out of money,” he added. “If you are paying our vendors in 45 days and your customers are paying you in 90 days, that’s generally a problem.”

4. Monetize Fixed Costs.

You already have fixed costs, such as a depreciation, taxes, maintenance, salaries and benefits in addition to a CEO, a CFO and a VP of Operations and other SG&A costs.

When demand starts to rise, manufacturers should be quick to generate a bigger return from their costs. Today, you run one shift, but why not add another shift for a much smaller investment since plenty of infrastructure and staff is in place?

CFOs could run the numbers and sell the idea to their CEO. They can show them what profitability might look like in 12 to 18 months. The projected numbers can even tell manufacturers when to add a third shift.

“Demonstrate how certain costs are variable and move with volume and some are fixed and don’t move,” Cardamone said. “With business owners, we explain which costs land in either of the two buckets. A CEOs salary doesn’t go up because you produce more widgets, but the parts for the widgets (variable costs) will increase with volume.”

5. Protect Borrowing Capabilities.

When manufacturers rely on an asset-based line of credit, they must make sure their lender’s terms match their customers’ terms to support operating cash flow.

Most business use a line of credit to help with short-term cash flow demands. If the business doesn’t have enough cash assets to cover the loan, the lender may require other types of collateral, such as accounts receivable, which are more liquid than physical assets.

But there’s one important point.

“If you are borrowing based on your account receivables 90 days out and your customers are not paying within the timeframe, it will limit your borrowing capability,” said Appleman, who has held the role as chief financial officer for growing privately held companies. “That will disqualify customers from your borrowing base, and it will limit your borrowing capability. It’s a multi-faceted problem that a good CFO can quickly fix.”

6. Leverage Data to Engage Your CEO.

Company cultures, which include manufacturers, do not value the decision-making capabilities that analytics can provide, according to a recent report in the Harvard Business Review. In addition, a Deloitte survey of U.S. executives found that the majority (63%) didn’t believe their companies were driven by analytics, while 67% said they were not comfortable using data from their resources.

Cardamone said education is the way companies must engage the CEOs to ensure they are part of the process. After all, it is the CEO who has the authority to bring the entire company together. Financial statements and financial records aren’t only about the Finance Department. It also includes team members in Credit and Operations to name a few.

The CFO could show the CEO the projected impact on operating cash flow if accounts receivable were moved from 45 days to 60 days or if inventory were reduced from 30 days to 15 days.

“Those are the kind of things to show a CEO in terms of margins and operating cash flow improvements,” Cardamone said. “It must be data-driven information that would make an impression on CEOs. The numbers could motivate them to make some changes.”

CFO Consulting Partners is comprised of a team of senior financial executives. We provide a broad range of financial management services to public and private companies. We work for CEOs, CFOs, as well as audit committees and boards. Our mission is to apply our consultants’ considerable collective experience to resolve client issues in a professional and efficient manner.

Blog Contributors:

Gary Cardamone of CFO Consulting Partners has over thirty years of experience in the private sector in manufacturing and engineering services. His expertise includes strategy and business development, mergers and acquisitions, divestitures, turnarounds, business modeling and financial planning, as well as sales and operations analysis.

Jeffrey Appleman of CFO Consulting Partners has more than 30 years of experience in public accounting and the private sector. He has served small and medium sized, growing privately held companies. His expertise includes accounting operations, restructuring, financial reporting and mergers and acquisitions.

(David DeMuth, a co-founder of CFO Consulting Partners. He leads the firm’s Real Estate, Manufacturing and Healthcare industry practices and co-leads the firm’s Technology, Transaction/M&A and Private Equity practices.)