Entrepreneurs are competitive people. Very competitive. As such, they want … no, they need a scorecard. They need answers to the questions of: Am I winning or losing? Gaining or fading? Kicking butt or simply getting kicked? The scoreboard of choice? It’s the income statement, of course. It’s so clean there. More is more, and less is simply, “getting kicked”.
Entrepreneurs focus obsessively on the income statement. It’s their bragging rights. It’s what they talk about at the country club and with their CEO groups, vendors, family, and friends. What they don’t talk about is their balance sheet. They may talk about cash, but that’s about it. And that’s too bad. It’s misguided and simply wrong-minded. Your income statement tells you how fast you’re going, while your balance sheet tells you how long you can stay in the race at that pace. The balance sheet is the fuel tank, and the working capital is the jet fuel inside that tank.
The problem is, most entrepreneurs don’t understand working capital. They don’t understand how to manage it, how to use it as fuel, or how do you make sure it’s there to achieve your dreams. And let’s face it. Dreams are the reason you started this business in the first place.
So, let’s understand how working capital drives cash, drives profit, and drives growth. The following story will highlight exactly how that happens.
The Tale of Two Companies – Why Managing Working Capital is Critical to Your long term Success.
Working capital is defined as the difference between a company’s Current Assets and its Current Liabilities. Typically, the most important components of working capital are Cash, Accounts Receivable, Inventory, and Accounts Payable.
Suppose there are two companies and both companies have the same level of revenue, and both have the same gross margin. To keep this example as simple as possible, we’ll assume that both companies have the same cash balances. We’ll also assume that the customers of both companies have terms of paying 100% in cash as soon as the company ships the product. Therefore, NO Accounts Receivable! Lastly, we’ll also assume that the vendors of both companies are paid 100% as soon as the product is received at each company’s dock and is recorded as inventory. So, NO Accounts Payable either! Just inventory and identical cash balances as the primary component of working capital.
Same Revenue, Same Margins, No AR, and No AP. Furthermore, because both companies have the same size, we will assume that their sales and administrative expense are the same. Thus, their profits are precisely the same.
Now, the only thing that is different between the two companies is their inventory and how they manage it.
Company A stocks and sells its entire inventory every month (12 inventory turns a year), while company B only stocks and sells its inventory every six months (2 turns per year).
This means they move the same amount of inventory in the year but on different timelines (same sales, the same margin means the same COGS and the same amount of merchandise sold during the year). So which company is healthier and why, despite having the same revenue, same margins, and same profits?
To determine who is healthier, we will make another assumption. Suppose that on an annual basis, both companies have COGS of $600,000 for direct materials (no labor, etc.)
Company A turns its inventory every month, so its inventory balance is $50,000 ($600,000/12 months), while company B’s average inventory is $300,000. Company B has a ton more CASH tied up in inventory. So, where does that cash come from to fund Company B’s inventory?
There can be three possible sources for this cash:
- Debt: Company B must borrow $250k more than A,
- Company B must postpone other strategic or tactical initiatives they have planned to improve the company because it must have enough CASH to fund the inventory. Effectively, Company B must delay its growth plans to fund inventory!
- The owner can invest $250k of her cash back into the company or forego distributions she would make to herself. Either way, it’s less cash in her personal pocket.
So, when a business elects to have large inventory balances, they are also electing to have more debt, slower growth, and less cash for the owner. You are simply deciding to have less of everything else.
Here’s another way of looking at this same picture. Because Company A turns over its inventory every month it has a “Cash Conversion Cycle” of only 30 days.
- Company A only needs to fund 1 month of operations to stay healthy and in business before proceeds from monthly sales of their inventory replenish their cash.
- Company B must fund 6 months of operations to stay in business before the sale of their inventory creates cash receipts to replenish cash.
Now, how will you assess which company is healthier? Which is undergoing more stress? Which has greater flexibility to build on their future? Which is more capable of taking care of their people in a sustainable way?
That’s why the “cash conversion cycle” holds so much importance. It reflects how long you must fund operations before cash replenishes. Because we made AR and AP zero, inventory is the only thing affecting the cash conversion cycle. Normally the cash conversion cycle in days is: AR Days of Sales, + Inventory Days in Inventory – AP Days in Payables. This simple formula tells you how long it takes for the cash you spend on inventory to come back in as an nAR collection. And how long you must fund the operations of your business.
How Does it Impact Company B’s Bottom Line?
This model seems too simple and too nice, and here’s why:
Company B is at a huge disadvantage. The cost structures of the two companies can NEVER BE THE SAME.
- Company B will always have a higher cost structure and fewer PROFITS. Their warehouse space must be 6 times more than A’s. They will have more racking, lift trucks, and warehouse employees than A. They have more assets on hand, so their insurance and property taxes will be higher, etc.
- With fewer profits, it will take Company B much longer than Company A to save $300k to fund their operations for 6 months. All of these further delay their ability to fund strategic initiatives to grow the company – a significant sacrifice they will be making.
- It’s also worse for Company B because a bank will only let it borrow 50% of its inventory value. So, while Company A might have to borrow $25k against their inventory, Company B must borrow $150k. Again, more costs and more risks!
- Furthermore, Company B is at risk of a significant “liquidity event” that a bank can cause. Many banks exclude inventory over 6 months old from the borrowing base. So, if, for some reason, it takes 7 months to sell the inventory rather than 6, then Company B must come up with $150k to repay the bank just when it is at its lowest point of cash availability. It depleted the $300k used to operate the company for 6 months and has no other cash reserves to satisfy the bank’s demand. This is what’s referred to as a liquidity event or liquidity crisis.
- A huge issue, a huge distraction, and, worse, the employees feel the stress and grow concerned over the business’s health. Unfortunately, when a company is in distress, too often it is the best employees who usually are the first to leave, because they can get a job anywhere, including a job with your competitors.
The purpose of giving you a real-life scenario example is to clearly emphasize the importance of working capital for your business. Managing working capital is crucial to managing the company’s cash position, which DIRECTLY AFFECTS its stability, health, and ability to execute its 1-3 year plans for the future in the timeline it wants.
This should also highlight the need for developing Key Performance Indicators (KPIs) for your balance sheet and especially your working capital. Once these are done, include them in your performance dashboards with targets for each to indicate if you are “Okay” or need to take corrective actions.
At New Life, CFO Services our favorite KPIs for Working Capital are Days Sales Outstanding, Days in Inventory, Days in Payables, Cash Conversion Cycle, and Op Liq (Operating Liquidity). Once understood by all, managing these metrics can be delegated to the primary person who manages, Cash, AR, Inventory, and AP. Our least favorite Working Capital Metrics are Quick Ratio and Acid Ratio because few people know what these are and how their actions and behaviors drive these metrics.
In closing, always know that while your friends may forgive you if you move your ball in golf, your spouse may forgive you if you forget their birthday, no one, and we mean NO ONE forgives you if you ever run out of cash!
- Working capital is a critical driver of cash, profits, and growth.
- Working capital is the jet fuel to enable your ability to achieve your dreams
- Key metrics for Working Capital are Days Sales Outstanding, Days in Inventory, Days in Payables, Cash Conversion Cycle, and Op Liq.
- Excess inventory or poor management of Working Capital will:
- Reduce your profits
- Slow your growth
- Increase your financial risks
- Minimize distributions to owners or investors
If you need help in further understanding best practices for managing Working Capital, Defining KPIs and their related targets, or building a suite of dashboards including critical performance of your balance sheet, then call us at New Life CFO Services.
We’re here to help.