Contrary to our first thoughts, “Where did my working capital go?” is often the question that a “Successful” business owner asks. Most people look at a successful business and immediately think that the business must be loaded with cash. Unfortunately, this is not the case for most midsize businesses. Having a successful business is a wonderful thing, but it is also a cash hog in many cases. Take a moment to think about businesses such as a wholesaler, a manufacture, or even a doctor’s office. All these businesses can be very successful if managed correctly, but they also take working capital to run so your money tends to disappear very quickly when the businesses are in growth modes. This article will describe how working capital problems frequently occur, the planning & preparation needed to manage it, and the financing & factoring invoice strategy as a solution…
So you get your tax return and there appears to be a nice profit (and a nice tax bill as well), but your bank account does not show any more money, and potentially could show less than the previous year. So, where did your money go?
The simple answer is that your money is not gone as long as you have been profitable… The two biggest areas that money or working capital tends to disappear is inventory and receivables. Monitoring your balance sheet on a monthly basis is a great way to watch your inventory and invoice trends, but this is not always as easy as it sounds so let’s discuss some practical examples.
A successful entrepreneur that has achieved the next level of sales can sometimes best be described in cliché terms as a “victim of their own success.” Let’s analyze a company’s need for working capital through the following examples. A company that has sold goods with total annual sale of $1 million or less often can use their own resources, but when sales move to the next level such as $2 or $3 million per year, a whole new level of working capital and management is often needed. Technically, if your customers are ordering $100k per month with 30 day terms, then sales of $1 million per year can be typically maintained with approximately $200k in working capital (a little more is needed for other items as well but these numbers can manually added). In our example, $100k is used for current invoices and the other $100k is used for production of incoming goods (aka inventory) for the following month. Now, if sales move to $2 million per year, then $400k in working capital would be needed. And with $3 million in sales, one would need $600k in working capital at minimum. Now, let’s say your customer(s) needed 60 or 90 day terms to pay their invoices, such as Walmart, Pepboys or other larger retailers. This would double or triple the estimated working capital needed. For example, selling Pepboys $3 million per year with 90 day terms would require approximately $1.8 million in working capital. Therefore, growing sales from $1 to $3 million can be very painful if the right amount of working capital or financing is not in place.
Often, a small to medium size business does not have enough working capital to meet its fast growth needs, so how does it tackle this issue. Factoring invoices can be a suitable solution to provide working capital for a fast growing business. Factoring is the process of converting invoices into cash. So based on our Pepboys example above, the $1.8 million working capital requirement to sell to Pepboys could be reduced by $1.5 million. Therefore, the entrepreneur selling to Pepboys could reduce its need from $1.8 million to $350k. There are other financing tools that commercial lenders that can provide such as purchase order financing that could further reduce the business’s working capital needs to approximately $100k. The take home message of this story is that if the right commercial lender is used, then a company could grow to $3 million in sales using approximately same amount of working capital that a company doing $1 million in sales uses. This is the efficiency and power of alternative financing not found at banks. There are few specialty commercial lenders such as PMF Bancorp that offer all of the working capital tools like invoice factoring, purchase order financing, lines of credit, and credit protection which are all the tools needed to grow sales by 3x without needing more working capital.
