October 31, 2014

Don’t Get Trapped: Working Capital

Don't Get Trapped: Working CapitalEvery company I speak with wants to grow. Growth is a sign of vitality and is or should be a source of profit. Perhaps, profitable growth is a better way to describe what everyone aspires to achieve.

If that is the goal, then what gets in the way more often than anything else? The answer is two-fold.

The first explanation involves “people working on the wrong things. Inadequate staffing in quality of quantity can stifle growth. But so can spending valuable people-time working on the wrong things-either customers or products that are not profitable or market segments that are unattractive (for a whole range of reasons)-or it could be just battling complexity caused by customer, product or market proliferation in the past.

The second (and most common) problem is shortages of working capital. Few small companies and a surprising number of larger ones overlook what I call the “working capital trap.” Here’s how companies fall into the working capital trap and what kind of damage it can do.

A New Product is Born

In most cases the outflow of money starts immediately (in any project, job, etc.) and the inflow is delayed-often for a very long time. Take a simple example: a product introduction. Money is spent developing the product idea and documenting it. Salaries, expenses, prototypes, intellectual property filings and many more causes must be funded before a product can be sold.

Next, the product must be marketed and sold. This also costs money and takes time. Sales calls, travel to customers, marketing materials, advertising, promotion, making and shipping samples all require expenditures. All of these expenses hit before the first sale is ever made. After a sale is made and the order taken, more expenses come next.

Materials/services must be purchased and labor spent to convert materials into parts and then into the products. Additional expenses like outside services, rent for facilities, insurance, etc. are also required expenses. Even if there is vacant space in existing facilities, there are costs for supplies, setup and supporting staff.

Finally, you have products to sell and are ready to ship. Picking, packing and loading the products come next. That takes manpower and money, and more supplies (cartons, banding or shrink/stretch wrap for palletized goods, labels, forms, etc). Unless the right freight terms are negotiated, the freight may also be an upfront expense to pay.

At last, the invoice can be sent to the customer, and then you wait for payment. Most terms are at least 30 days… or more. Still, no money has flowed into the company. Every step I have described thus far requires money-working capital-to pay the bills that are incurred and come due along the way.

The “cash-to-cash time” is the time from when the first spending until the payment for the first shipment is received. Cash starts flowing out for salaries and office expenses when the product/service creation starts, and goes on from there until a sale is made and the payment collected. It is not unusual for the “cash-to-cash” time to be nine months-or more (the gestation period for a human baby). And yet, few companies even know what their “cash-to-cash” time is. Hundreds, thousands or even millions of dollars might be spent before a single dollar is received in payment.

TO DO: Calculate your cash-to-cash time on a major new product/project.

Working Capital

What covers these expenses? Working capital. Where do you get it? From retained earnings derived from prior profitable time periods, or from loans-which seem to be harder and harder to get. Careful planning can reduce the required working capital needs. Some industries require a deposit with the order (typical in large, single purpose capital goods items). That helps. Some companies can negotiate extended terms with suppliers, and even hold off some supplier payment until customer payments are received. But this is uncommon.

TO DO: Make a 13-26 week detailed Cash Flow-in & out-projection week by week.

Growth Increases the Need for WC

The first product was a success and the next round of orders is much larger. What do you need more of then? More parts, more labor and more working capital to pay the bills while the product is being produced, sold and payment is coming! Thus the result of success is the need for even more working capital. Then this cycle repeats itself. IF the product is handsomely profitable, the profit can fund part of the new working capital need, but usually only a fraction of it. That means more investment from company owners or larger loans from the bank.

TO DO: Make a projection of the added working capital needed to provide cash flow for a sizable increase in sales.

The Bigger You Get, the More You Need

Growth is great; profitable growth is even better. But even then, it is necessary to find, earn or borrow enough working capital to cover the cash flow needs of the cash-to-cash cycle. How much will you need? That is where the “forward cash flow projection” listed as a TO DO earlier becomes critically important. This projection lists, by time period (usually weeks) for a period into the future every outflow of cash and every inflow of cash, in the time period when it is expected to happen.

Once this is done, what’s left at the bottom is called “availability.” That means how much cash (working capital in a real sense) you have left as of that time frame. If availability is projected to go negative (you run out of cash), that is very bad. You can’t pay bills or maybe even make payroll. When a customer is late paying you that reduces your availability still further. Can you survive that?

Suppliers may make it worse if they sense your company is in a working capital bind. Since they fear not getting paid, they may shorten payment terms or even demand cash in advance for materials. This is a very bad situation, indeed, since it drains your working capital and cash even faster.

Cash Is King

You may have heard the phrase, “Cash is King.” This is where it comes from. You might make a handsome profit at year-end-unless you never get there because you fell into the working capital trap and ran out of cash. That is how many otherwise competent companies fail and are forced to either go out of business or file bankruptcy and hope to reorganize. Now you understand the “working capital trap.” You are now aware of a few important TO DO steps. Forewarned is forearmed. Don’t let your otherwise viable company fail because it fell into the working capital trap.”

Editor’s Note: This article was previously published at OPENForum.com under the title: “The Working Capital Trap” It is republished here with permission.

5 Comments ▼

John Mariotti


John Mariotti John Mariotti is an internationally known executive and an award winning author. In The Chinese Conspiracy he merges a fictional thriller with factual reality of America’s risk from Cyber-Attacks. John does Keynote speeches, serves on corporate boards and is a consultant/advisor to many companies.

5 Reactions

  1. Nice post. I like how you point out that working capital problems can surface at the time when they feel most successful – when a very large order/s arrives and the business is growing. Suddenly, they spend a lot of resources servicing the orders, run out of money and into problems. This is all too common, and many times preventable.

    Mishandling growth can kill a business as quickly as any other thing.

    –Marco

  2. Great insight. We tend to think of capital in terms of start-up purposes, but working capital, even in the “good times” is vital to any business’ success.

    Thanks for the info.

  3. Just like in almost any other field, a rapid growth is a sign of imbalance. There has to be a good and feasible relation between resources, potential and profit. I think this article proves once again that strong resources manage decent outcome.

    Lloyd Burrell
    Publisher
    officedeskreviews.com

  4. John,

    Thanks for this financial primer. I will bookmark it and reread several times.

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