Watch the video: https://youtu.be/66DAP-nKjNQ
This week I got a small business
finance management question from Phil, who asks: What about working capital?
Where can I get it and what is the cost?
Before we get into that though,
what do we mean by working
capital? Working capital is the money that you have to invest in a business to
get your products or services from the point where you start working on your
raw materials or start creating your services, up until to the point where your
customers pay you. As the business grows, the operating capital may have to
grow, and if we don’t grow too quickly and we are profitable we should be able
to grow the operating capital as we grow our profits and grow our business. This
is financing working capital through Retained Earnings, sometimes this is
called ‘bootstrapping.’
If we are starting up a new business
or if we are growing too rapidly, we may not be able to afford bootstrapping
and may need outside sources of operating capital.
For example, let’s say I buy raw
goods and I have to pay for the
goods when I get them. Then it takes me 30
days to transform them into my finished products. Say its 10,000$ worth of stuff for this example. It takes me a month in order
to turn them into my finished products, and then I sell it immediately to my customer, and he takes 30 days to pay me. So
I’ve got $10,000 tied up for two
months before I get paid and my cost recovery as well as my
profit is received.
So if I sell $10,000 worth of products every month, how much operating capital do I need?
Well it’s not 10,000 because when my goods that I bought is at the beginning of
the month are completed. I then sell them; I start waiting to get paid but on
that day I have to buy another 10,000 worth of product to start working on for
the next month’s deliveries. So I actually need $20,000 worth of working
capital for a company that has sales of $10,000 a month if we have to spend the
money up front and collect sixty days later from customers.
So where do we get operating
capital? First we’re going to start by
looking at the balance sheet.
Assets are on one side of the
balance sheet and your assets always have to equal your liabilities and your
equity which are on the other side.
On the assets side you have cash
in the bank, receivables, inventory and work in progress. On the other side are liabilities; you’ve got
payables, this is money you owe your suppliers, lines of credits and credit
cards.
I’m not discussing loans here
because typically bank loans are for capital goods, things that you use over a
long period of time. Usually when we’re
talking about operating capital a bank will create a line of credit and they’ll
secure that with a lien against certain assets typically inventory and
receivables. The idea being that the line of credit goes up and down over time
whereas a loan is usually secured against a fixed asset that we know has a longer
life and maybe we’re going to pay for over several years.
In the equity section, we have
retained profits (or earnings) which is simply the profits of the company that
we haven’t removed. We leave that money in the company to help the company grow,
remember when I mentioned bootstrapping?
The owner’s contributions also
appear in the equity section. It’s the
money the owner’s put into the business to help it function.
When you start off a business of
course you don’t have any retained profits but you probably have some money of
your own that you put in to help to get going.
Next you go to the bank and say
‘look I need some inventory’ and let’s say the bank agrees that the inventory
is a certain nature that they don’t mind making a loan. What we call fungible
inventory that’s non-perishable so two-by-fours for example are fungible. It
doesn’t matter who made them or how old they are, they still two-by-four pieces
of wood.
Non-perishable means that it
doesn’t have an expiry date that’s upcoming. So for example, it’s much more
difficult to get the banker to give you an inventory financing for lettuce,
because if we don’t sell it in time it goes rotten and then the value of your
inventory disappears. It’s difficult to get inventory loans against for
example: ladies dresses because at the end of the season they may no longer be
fashionable or suitable for the time of the year and all of that sudden your
inventory again has no value, so if your inventory meets certain criteria you
can get a line of credit.
Now the question was what were
the different costs for different sources of operating capital, so payables is
money that we owe suppliers and payables typically we get 30 days before we
have to pay our suppliers in certain industries some industries go longer 45,
60 even 90 days or longer and you can negotiate sometimes those terms. So
really you can finance operating capital from payables for 0%, because it’s
literally your suppliers investing money in your business and depending on your
relationship with them. They have the power to be very generous with or maybe
if you’re someone who doesn’t pay your bills on time and they get frustrated with
you, then of course they demand cash on deliveries, COD which means you don’t
have access to this type of working capital at all.
Credit cards if used wisely can
be 0%, why do I say they’re 0%? simple. You use a credit card to buy some
goods, when the statement arrives you have a certain number of days to pay it
in full on time and if you are set up in proper order and you pay that credit
card in full every month on time, you never pay any interest charges. If you
are not well organized and disciplined, then you know 9 to 29% is the cost. If you want to learn more how to properly use
credit cards in a business, then you should read my book Credit Card Advantage
is available from Amazon and from the www.InvestLocalBook.com website.
So what is the cost of equity? Basically
you have to know what sort of return you demand of your business and if your
business is struggling to grow and you’re just starting off you’re probably not
demanding much of a return in your business.
In bigger companies they often look at the return on equity as one of
their key performance indicators. In big publicly-traded companies,
shareholders often demand a certain dividend based on their investments in the
shares. So they can actually calculate the cost of this source of capital as
well.
However, a lot of the time our
challenge with operating capital is not actually a challenge with operating
capital, it is a challenge with cash-management. In the example I started off with, you buy
$10,000 worth of inventory, your cash goes down by $10,000, your inventory goes
up by $10,000, you then spent thirty days converting that into your finished
product, so then the inventory goes down by $10,000 and your work in progress
goes up by $10,000, these are all still assets. We’re just changing where on
the balance sheet or what form these assets take. We then shipped the products
to our customer we send them a bill, it changes from work in progress back to
inventory briefly, finished goods and then changes into a receivable.
So again the capital is just changing
its form on the asset side, so a lot of the times in a small business you might
have a whole bunch of receivables. On paper you might have enough operating
capital but it’s not in the right form, so there are other ways that we can convert
the form of capital.
For example, if you have a lot of
receivables and you need cash, you can use a process called factoring. What
factoring is you convert a receivable by selling the receivable, so your
customer no longer owes you the money, they now owe it to the factoring company
and the factoring company pays you an advance on that receivable so $1,000
receivable if you sell it to the factor they might give you $800 today. So now
we’re moved money from the receivable line into the cash line and when the
customer ultimately pays the factor, they may withhold $30 or 3% fee for
example, then send the other $170 to you.
This is the same goal that
companies have when they accept credit cards as payment. They’re also paying a 2-4% fee in exchange
for immediately having cash and not a receivable.
So if you’re relying on it, month
in and month out every month, you could look at it from an annualized point of
view and say that you know it costs over 30% but with factoring a lot of
companies that do factoring in some parts of the year or they factor certain
customers but not other except just to give themselves the amount of liquidity
or cash in hand, that they need to keep things functioning.
Changing Inventory into cash
would look like a liquidation sale.
I hope that answers your
question. All the assets except cash are uses of operating capital so we’re use
our capital literally to finance receivables, the inventory and the work in
progress. The liabilities and equity are
actually our sources of operating capital. Where we get money to help our
business go.
If there are any other questions
about this kind of stuff, please don’t hesitate to send me an email Dbarnett@ALPatalantic.com. Don’t forget to visit my blog site. www.DavidCBarnett.com to sign up for my
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my latest videos first. Thanks.
