Effective management of working capital is crucial to the health of any business. Michael Sutherland examines the factors involved in achieving the right working capital balance.
When was the last time you looked at the cost of doing business, calculating the working capital your business needs to break even? Taking the time to conduct regular checks on working capital is an important task to ensure a healthy balance sheet and tighter management of your cash flow.
Working capital is a term used to define the short-term funding required to run a business at a particular turnover level. The basic breakdown of working capital is:
Cash at bank + stock + trade debtors + prepayments + sundry receivables, less trade creditors + accruals + sundry payables.
For many businesses, the amount of working capital required to run the business will be significant. For businesses with high turnover, there may be a large amount of funds tied up in their debtors ledger, even where they are able to efficiently manage their stock holdings (so the value of stock on hand is not much more than the amount payable to creditors).
Usually the larger the revenue, the larger the working capital. Given this, the business owner will be required to fund the business until such time as these receivables are converted into cash.
Every business owner should quantify the costs of keeping the doors open. By analysing this, businesses can determine what they need to achieve, in terms of gross profit margin, to defray costs and break even. This can be done quite easily by most business owners on an annual basis, but these costs should also be scrutinised on a monthly or even weekly basis, to be aware of the peaks and troughs in their business cycle. This is particularly true for businesses that experience seasonal fluctuations in sales.
Having done this exercise, the business owner will now understand the level of gross profit required on a weekly basis to ensure the business is running at a profit.
So, let’s presume our business owner is selling product and turning a nice profit, have we solved their problems? Why is it that most, if not all businesses that are profitable and growing, experience cash flow shortages?
Remember the cliche: growth is vanity, profit is sanity, but cash is king. When businesses increase revenue, they require more working capital. The owner must keep buying in more stock to fuel the sales growth and these sales again may largely sit as receivables for 30 to 60 days when they are converted to cash. In the meantime, wages, rents, supplier and debt payments put pressure on the business’ cash flow and just when you think you are getting in front, in rolls a quarterly income tax or GST bill. A vicious cycle.
Although this is a good problem to have, because it means you have a growing and profitable business, it identifies a quandary.
As a business owner, there are two important aspects to focus on: profit and cash flow. To turn a profit, the business owner has to be able to identify all costs of doing business. They then have to generate more in gross profit, so after paying all overheads the business has an excess, or a net profit.
Just as important (and more in some cases) is the focus on cash flow, with both long- and short-term views. This focus will ensure business owners will not give away profit simply to get more funds in quickly, either by discounting sales prices for cash sales, or by factoring their debtors and wearing an additional financing cost. Both of these strategies can reduce profit margins and, ultimately, the long-term cash flow.
A business owner should always be aware of their business forecasts. In particular, they should prepare a forecast profit statement, a cash flow statement, and a balance sheet forecast on a monthly basis. This is often referred to as a three-way forecast. By doing this, the owner is aware of the extent of the expenses of the business and can then determine the required level of sales to achieve a profit. But they can also identify any pending cash shortages so that they can adjust their banking facilities before they reach their overdraft limits.
Effective working capital management requires continual review and diligence in keeping stock levels down in addition to ensuring that the debtor collection and creditor payment functions are optimised. If you can manage this balancing act, while growing your gross profit margin, then you and your business will be running at optimum performance given its current sales.
Understanding working capital is fundamental to running your business effectively, but it can also give you the edge when considering a business acquisition. Unfortunately, funding working capital gets forgotten by some businesses during acquisitions.
There’s no shortage of advertisements representing businesses for sale, often asking for a price plus stock at valuation. From a buyer’s point of view, though, there’s more to it than that.
Misrepresentation of working capital is frequently seen when a business owner expects to sell their business, keep the debtors’ balances, and collect them in addition to the sale sum. In these scenarios, what should the acquirer do about working capital?
For example, say you decide to acquire a business for four times its future maintainable earnings. This would indicate you are prepared to pay $4 million based on the reckoning that you will buy an income stream (the profit or future maintainable earnings) and require a 25 percent return on your investment given the risk profile of the business.
If you haven’t been provided with any working capital, you will automatically come across a hurdle. How will the bills be paid in the first week of trading?
Staff wages, rent, loan repayments and so on must all be paid immediately, whereas sales from this newly acquired business are most likely to be largely on a credit account. So, as the acquirer, you would need to fund the working capital in addition to the purchase price. This of course means there is more than $4 million at risk and would indicate that as the purchaser, you have paid more than you should have! A good understanding of working capital will help avoid trouble.
* Michael Sutherland is director of Entrepreneurial Services, with Grant Thornton (www.grantthornton.com.au).