Preface: Why is working capital management important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost”. Working capital is the science of cash flow management – an important fuel to any business craft.
Investing to Double Your Business’s Value – Part IX
Appreciation for astute working capital management is pillar nine of doubling your business’s value. Working capital techniques are vital to any entrepreneurial business; the difference between current assets and current liabilities is working capital simplified. A business with deep pockets, has plenty of working capital. Yet too many entrepreneurs do not understand the term working capital, nor the value of expert working capital management. (If you’re an entrepreneur and your business advisor or CPA has schooled you in working capital management — please take the time to email me; no response is a vote.) Cash flow management is a more frequent term applied to the science; but working capital management is the appropriate application of cash management, i.e. trend setting.
Working capital is the fuel of business. Often your lead technicians, sales team, production supervisor, shop supervisor, or office staff are not attending to working capital or cash flow management, and yet calculating and maintaining optimal levels of working capital is imperative, and as important as good customer service, or product quality, for any business.
Working capital can be segregated into level one and level two balances. Level one working capital is a minimal balance of working capital required at all time. Dip below that level = fuel lights. While a business current ratio measures working capital metrics, it doesn’t give you a level one or level two balance requirement. Level two is peak working capital requirements for peak season cash requirements, e.g. financing holiday inventory levels.
Few entrepreneurs have an adequate understanding of what their business level one and level two working capital balances should be; and fewer have accurate accounting records to calculate the balance. In order to accurately calculate working capital, you need to account not only accurately for inventory balances and accounts receivables on the assets side, but also for current liabilities, e.g. portions of long-term, accrued payroll, accrued expenses; and of course, accounts payable. This requires accurate accounting records.
Working capital, or operating cash liquidity, can be measured with a formula of currents assets, i.e. accounts receivable days + inventory days – current liabilities, i.e. accounts payable days. Therefore if your average accounts receivables are 30 days and $50,000 and your inventory is an average of 50 days or $100,000 and your accounts payable are 20 days or $30,000, then the $50,000 + $100,000 – $30,00 is your working capital requirement, i.e. $120,000. If sales are $1,200,00 your business working capital is 10% of revenues. Inventory increases financing on a line of credit will increase both the numerator and denominator of the current ratio. Operating expenses financed with a line of credit will only adjust liabilities and equity, e.g. assets stagnate while liabilities increase.
Now you’re likely asking how is working capital management applicable to doubling business value? Each adjustment to current assets or liabilities is an adjustment to working capital or operating liquidity. Let’s consider a hypothetical scenario. If a business wants to expand and increase sales with the assumption of a $50,000 software development contract it will need to increase working capital based on the % of those additional potential sales, i.e. it is challenging to increase value without increasing revenues, e.g. you will need finance the cost of the contract either with customer deposits or other sources of cash say equity or debt.
For a service business that has only accounts receivables and accounts payable the scenario would work like this example. With $150,000 sales a month, and $145,000 of expenses per month, if receivables are 30 days and payables 30 days, then working capital before cash balances would be $5,000. In this scenario working capital would 2% of revenues, before cash is added.
A child once ask a successful businessman what was required to be in his industry. The response: Deep pockets. In accounting that is working capital. Software businesses that invest $4m say in development of a license must have adequate working capital to finance the start-up development and programming phase leading to implementation. If your business burn is $20,000 per year on start-up, you need working capital access to fuel the craft.
A secure business often has a current ratio minimum of 2.0 – 2.5 typically. This business’s current ratio would be a concerning 1.03, before cash. Therefore, unbeknownst to many, firstly, increased sales are connected to increased working capital, i.e. current ratio management. In this example, the business would need cash reserves of $140,000 before it should embark on a business expansion of sales revenues from a CFO advisor perspective, e.g. cash of $140k + AR of $150k / AP of $145k = current ratio of 2.0.
If the business has $20,000 of cash it should not plan to immediately implement to double business value. It should plan instead build a foundation of solid level one working capital, i.e. $140k of cash, before implementing increases in sales; and therefore associated overhead expenses.
Once the business builds the foundation of the accurate financial metrics, then it would need to calculate the sale increase and working capital requirements. In the above example the $1.8m of sales with $145k or working capital would equal 8% of sales. Therefore, for every $100,000 increase of planned sales would require $8,000 of working capital. Every entrepreneur should understand the science of working capital management to ease financial management and make more informed decisions. [Too many entrepreneurs rationalize financial performance without adequate financial oversight, i.e. analytical intelligence, resulting in non-optimal performance. The opportunity to access analytical resources for the entrepreneur with powerful accounting software is quickly changing the landscape of small business accounting. Authors note]
A good CPA is more than a qualified tax preparer or financial statement expert. For the astute entrepreneurs they are an advisor for financial decisions, with accurate financials as a map for business decision. To an expert CPA, financials provide insightful information that has substantial business value, i.e. well-advised decision making from financial metrics.
A business advisor consulting to develop your business should always rely on accurate numbers as a substantial factor in successful business decisions. Be very respectful of analytics and financial metrics, e.g. working capital calculations, because when appropriately applied, they can help you make very successful business decisions.
Again, why is working capital management so important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it? Lest haply, after he hath laid the foundation, and is not able to finish it, all that behold it begin to mock him, Saying, This man began to build, and was not able to finish.” Luke 14:28-30.
Working capital management in this blog context, is about proactively counting the costs when planning a doubling of your business’s value.
Part IX of doubling your business value– Working capital management.