What is working capital?

What is working capital?

When you start your business some of the language used to describe aspects of the financial operations can be mystifying to say the least. In this occasional series, our advisors explain some of the concepts – and language – that is used to give you a clearer understanding.

This week, Gordon Stuart gets to the bottom of working capital and what it means for a business owner. 

Put simply, working capital is used to cover all a company’s short-term expenses, including inventory, payments on short-term debt and operating expenses such as wages, salaries, rent and other overheads. Working capital oils the wheels and is used to keep a business operating smoothly in order to meet all its financial obligations within the coming year.

  • Working Capital is defined as current assets minus current liabilities and, if a business cannot meet its short-term debt obligations, it is experiencing liquidity risk. Running out of cash is what kills any business first.
  • Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value.
  • Cash is universally considered the most liquid asset, while tangible assets, such as real estate, fine art, and collectibles, are all considered relatively liquid.

Understanding your business’s working capital requirements and where your cash is absorbed is key to success when you approach a bank for support.

The first thing a bank looks at is:

The cause (where money has gone) and the purpose of your proposal.

What proportion is being provided by the bank, the business and other participants (e.g. second tier lenders, or asset financiers).

The intended use by the business e.g. to increase working capital to fund growth or to fund an acquisition.

Some questions you need to be able to answer include:

  • What is the length of your operating or cashflow conversion cycle? For example, an importing retailer needs to know how long it takes to get cash from retail sales from the time they source or pay for imports – often more than 3 months. Likewise many service providers do the work but don’t get paid for 30 – 60 days. More importantly do you know how to change the length of the operating cycle or identify ways to unlock cash to improve working capital or support growth?
  • What are your intra and inter month working capital requirements? Banks look at your daily and monthly highs and lows of your overdraft as an early warning signal of trouble.
  • How does productivity and seasonality impact your cashflows? For example – holidays and short months reduce labour productivity which usually has a negative cash impact, alternatively increasing production to build stock for the peak summer season absorbs cash.
  • How many months working capital do you have if you incur losses?
  • Do you have access to an injection of cash if needed?

If you are struggling to understand some of the principles or, like many business owners are learning as you go, don’t be afraid to ask for help – we’re here to do just that.

Managing a business boom

Managing a business boom

All successful businesses want to grow. However, rapid growth can be a mixed blessing, and unbridled growth can quickly become a burden with bottlenecks and organisational issues flaring – so how do you manage a business boom?

Growth brings new challenges across all areas of your business from staff to systems, to quality control, customer service, fixed costs, labour productivity, and to cash being absorbed by working capital.

Overtrading is a common cause of receivership after a recession as working capital is depleted –and fast growth means businesses simply run out of cash. Construction companies commonly fail because they take on too much work, are spread too thinly, leading to quality defects, weak project management and timetables slipping behind. Performance and liquidated damages claims soon follow.

Hence one of the most common outcomes if you are growing fast is the need to refinance with your bank, to provide facility headroom and liquidity to support your growth, as for many small businesses attracting new equity is not a viable or quick alternative.

While most companies plan and strive for growth, not all are adequately prepared to manage it when it happens unexpectedly and hastily. Fortunately, there are things you can do before you find yourself swimming in more business than you had ever anticipated.

Firstly, be certain that your company is not undergoing seasonal or one-time-only growth – in our volatile COVID world, expect the unexpected as a downturn or new lockdown could happen anytime.

Some questions to ask include:-

  • Do I have the necessary capital (equity and term debt) to finance my growth?
  • Do I have surplus assets that I could turn into cash if need be? This may extend to securing or re-mortgaging your house.
  • Am I expanding too quickly? Is it profitable gross margin business or is it growth for growth’s sake?
  • Am I hiring too fast? Have I got the right people on the bus, and is our labour productivity being maintained?
  • Am I collecting my receivables fast enough?
  • Is my inventory and stock turn in line with my growth?
  • Is my production line efficient? Are my input costs competitive, and is our supply chain secure?
  • Is our quality control and customer service falling?
  • Are our fixed costs or chassis right to run the engine?
  • Lastly, does my management team have the right competencies to handle our company’s growth? Where are our holes and blind spots?

The purpose of these questions is to diagnose potential weaknesses, where the cash is going or leaking and to gain more control over the key aspects of your business that impact cashflow.

A source and application of funds on your balance sheet can quickly tell you where the cash has gone – or is going – and profitability trend analysis is a vital component of your financial analysis. Trend is your friend.  Display your income statement in four different ways,

• $ for multiple periods / rolling twelve months
• Averages over the last four or five periods
• Common size expenses as a % of sales
• Dollars/unit e.g. in a restaurant $/customer or $/table or in a food business $/kg.

Common sizing quickly spots expenses that have changed – and highlights questions to be asked, the main question being why the change?

Understand your breakeven position and current headroom. Explore a range of scenarios that forecast your cashflow and future cash requirements when you hit targets, fall well short or knock everything out of the park.

Knowing this, you can look at your current financial situation and assess if you can make improvements. You may be able to get additional financing for working capital, restructure your debt or convert unused assets into cash.

Carefully consider how each situation would impact your business numbers in terms of employees, costs, resources, and so on. Knowing your threshold before a jump in growth occurs will enable you to recognise early on when you’re reaching capacity and allow you to react with agility because you already have a plan in place.

Invest in a well-built simple financial model that can provide these answers quickly. You’ll be thankful you’ve done it should your business suddenly take off.

Demonstrating strong management of receivables, stock, and payables plus control of overhead costs is key to gaining a bank’s confidence in your management team. Be particularly careful about maintaining cost controls during growth spurts where businesses often go on a spending binge.

Communicate early with your bank. Banks hate vacuums, and too many customers leave it too late to address refinancing needs. Understand banks like to be repaid and high growth companies usually need more debt support and are therefore regarded as risky.

You can also look for alternatives to conventional debt financing. For example, you may be able to negotiate better payment schedules with suppliers, or look at leasing vs. buying assets or asset financing for vehicles or plant, or maybe you can consolidate a number of loans to simplify things.

The key is to get the refinancing you need. Longer term debt with reduced monthly payments can be achieved by spreading your payments over a longer period.

After analysing your company, you will be better able to examine your ability to repay debt. A refinancing application is very similar to a normal financing application. In both cases, the lender establishes certain debt repayment conditions, which you must be able to fulfil. If you cannot demonstrate your repayment ability, the lender will not assume the risk alone.

New legal requirements imposed on Banks mean they require comprehensive business plans, strategy, and a credit story supported by both historic and forecast financial scenarios. This takes time and expertise to prepare. If it is not in your management team’s skillset – get independent advice.

In all cases you need to demonstrate:-
• Your management are competent and experienced
• The key risks are managed and mitigated
• That you have sufficient working capital and equity in the business
• That you can clearly demonstrate your ability to repay the loan/s

In conclusion, extreme growth is a good problem to have so long as you’re prepared for it. Combined with simple management strategies such as benchmarking stress points, empowering employees, optimising efficiency, and leveraging technology to create scale will put you in a strong position when your company finds itself on a hot streak.

Americas Cup shows innovation is a process

Americas Cup shows innovation is a process

As we marvel at the speed and agility of the four America’s Cup teams on Auckland’s harbour this weekend, it is interesting to reflect on how they got there and how they continuously innovate and improve.

To innovate you need an open and collaborative process and sometimes, businesses of all types rest on their laurels and forget the creativity and passion that got them started. Many years ago, Edward De Bono developed the Six Hats thinking process to encourage productive discussion and innovation in organisations, rather than blame or arguments. The Thinking Hats take away ‘right and wrong’ and encourage people working in a team to take different views.

First is the ‘Blue Hat’ that facilitates or conducts the process and keeps the team on track.

The ‘White Hat’ analyses – for example, it produces the engineering data which helps the high performance teams work out how to get the boats to go faster.

The ‘Green Hat’ is the creative hat full of alternative ideas – who else would have thought of leg-powered bicycle grinders on our boat in Bermuda?

The ‘Yellow Hat’ is the sunshine – full of optimism, it looks for benefits. In our Bermuda bicycle example leg muscles are larger than arms. This gave the AC50 grinders more power to supply the hydraulic systems which raise and lower the foils and pull in the huge wingsail.

The ‘Red Hat’ is the intuition hat, driven by emotion. “My gut feeling is this will or will not work.” Intuition is often built on complex judgement based on years of experience and may be an art rather than a science.  Boatbuilding is an art and it is worth reflecting that, in business, restructuring often fails because the human element, the emotion, is not properly taken into account.

The ‘Black Hat’ is the caution or critical judgement hat. Engineers try to make sure the loads on these boats are safe. Get it wrong and death is a real possibility. However, imposing too much health and safety too early can kill creativity.

The boats we see in January and February will be very different to those we see this weekend. The ‘Blue Hat’ will oversee continuously trialing and optimisation on the water – proof that innovation is a continuous process.

As a small business owner, you’ll be wearing many hats – De Bono’s colourful collection and the Captain’s Hat too, as you steer your enterprise through the choppy waters of 2020 and beyond. A start up business is often born from a Green Hat creative idea, or from an optimistic Yellow Hat applying someone else’s crazy thinking. Bridging the ‘valley of death’ and not running out of cash in a start-up requires a big Blue Hat to navigate uncharted territory. Often it takes many years – and continuous innovation – to get your business model right.

I am currently working with a customer whose Black Hat thinking began an innovation process, building an automated system that manages lead generation and marketing through to sales, operations, accounting and pricing. Any information technology system implementation requires all the hats to get it to work, and because of the new automation his net profit margins are now much higher than his competitors.

As your business matures, it is easy to become stale – competitors whittle away your super profits and you continue to cut overheads. If you look at breweries, beer is in decline, and they have had to develop or acquire new categories to achieve growth or sustain profits. Innovation and creativity is the lifeblood of your business and is underpinned by your passion for what you do. Keeping your creativity alive is essential, as is innovation because, if you stop innovating or let your creativity stagnate, you can end up like Kodak.

Kodak was so blinded by its success in selling film it completely overlooked the disruptive potential of the digital camera invented by Steve Sasson, one of its engineers, in 1975. However, the real disruption occurred when cameras merged with phones and people shifted from printing pictures to posting them on social media. Kodak missed the trend and had to deal with the resulting consequences.  

So remember as you watch the boats fly through the harbour this weekend, every captain must innovate, be prepared to change course and adapt – or run the risk of losing the race.

Changes to the Business Finance Guarantee Scheme

Changes to the Business Finance Guarantee Scheme

Gordon Stuart takes a look at the recent changes made to the government’s Business Finance Guarantee Scheme.

The eligibility criteria for a Business Finance Guarantee Scheme (BFGS) loan have been loosened from the initial terms detailed back in April. The maximum amount of the loan is now up to $5m. Note the first version announced by the Government in April provided $6.25b but was largely unsuccessful with only $150m taken up by 780 customers.

The BFGS loan use criteria have been widened, so your business (which can be a company, sole trader, partnership or trust) can use credit for (a) working capital (b) funding capital assets and/or (c) projects related to responding to, or recovering from, the impacts of COVID-19. Previously it was for working capital only.

I expect take up will be better this time towards the end of the year, as forecasting hopefully becomes easier.

Recessions since 1987 have generally reduced business revenues and cash available for debt servicing. This has resulted in longer debt payback thereby creating term debt needs.

To be eligible to apply for a BFGS loan your business must:

  • Be a New Zealand based business
  • Have annual revenue of $200 million or less in its most recently completed financial year
  • Not be on your bank’s credit watchlist as at 31 January 2020 (for retail customers) or 30 September 2019 (for non-retail customers)
  • Not be a residential or commercial property developer or investor, or a local authority or council-controlled organisation

The Participating banks ANZ, ASB, BNZ, Heartland Bank, Kiwibank, SBS Bank, TSB, Bank of China and Westpac are under pressure from the Reserve Bank to lend to their capped amount. However, their requirements for financial forecasts will still be tough. The better the quality of information you submit, the higher the likely success rate and the quicker the loans can be processed.

Here are some key points worth noting:

  • Under the scheme, the government will guarantee 80% of the risk associated with eligible loans.
  • The interest rate charged is lower, reflecting the Government’s 80% share of risk and should be (c.2.5% – 3%), up to 5 years and up to $5m. For Regulatory Capital Purposes the Government is zero risk weighted. The benefit borrowers receive is a lower interest rate.
  • If your business defaults, your bank will follow its normal process to recover the debt. If the debt can’t be recovered, the bank can claim 80% of any shortfall from the Crown. Note that the Government guarantee does not limit your business’s liability for the debt
  • For borrowers that have fixed rate lending already in place, consider break costs if you refinance existing fixed rate debt via a BFGS loan early.
  • The BFGS loan needs to be repaid over 5 years but can be repaid earlier at no break cost.
  • This scheme is also available to clients who are already on COVID-19 relief packages provided by the banks or have received the wage subsidy
  • The Scheme is open for applications until 31 December 2020.

Exclusions:

  • Cannot be on the bank’s credit watch-list at 30 September 2019 and 31 January 2020.
  • Cannot be a residential or commercial property developer or investor or a local authority or council-controlled organisation.
  • Cannot be used to fund dividends – note:- there is a guaranteeing group exclusion that you should discuss with your Bank.
  • Cannot be on lent outside the business.
  • Cannot re-finance or repay more than 20% of the business’s existing term debt (term debt only). Note – there appears to be an exclusion if debt facilities mature before 31 December 2020. Discuss with your bank.

Note:- Businesses do not have to draw down all existing facilities before applying for a BFGS loan as previously required in April.

As part of your bank’s approval process for a loan under the scheme, your bank decides:

  • The loan amount (up to $5 million under one or more loans), term (up to five years) and the interest rate
  • What businesses should provide to demonstrate ability to repay the debt, such as a cashflow forecast, business plan and details of assets
  • Whether it will rely on existing or require new security and guarantees to support the debt (this is not a Government requirement)
  • Whether it will approve or decline a loan under the scheme.

Finally to reiterate two common misunderstandings.

  1. Is the Government guaranteeing the loan?
    No. You will need to provide security for the loan as you would normally. The Government and participating banks have agreed to share the risk in case of default only.
  2. What kind of security do I need to provide for the loan?
    While banks remain in control of their own lending decisions there is no Government expectation or requirement that lending requires a general security agreement or personal guarantee. Note – Banks will require security! Their job is to take minimal or no risk for maximum return.
How Do You Survive a Recession?

How Do You Survive a Recession?

Guidance from Gordon Stuart on Recession Tactics

It’s been dubbed ‘bigger than the Great Depression’ and daily news of redundancies and restructures highlight we’re in difficult times but we’ve weathered challenging economic situations before – so how can we learn from the past and prepare for the future?

Ten years ago, Harvard University published research into the way companies respond to economic crisis and how their actions ultimately determine shareholder value in the future. Covering three recessions – 1980, 1990 and 2000 – researchers found that 17% of the nearly 5000 businesses studied simply didn’t survive. Those that did survive were slow to recover and three years on from the recession hadn’t regained their pre-recession growth rates for sales and profits. Only a small number – 9% – flourished and the winners were not as expected. Those that won through adversity were those with a multi-faceted strategy able to master the delicate balance between selectively reducing costs to survive and investing for the future, spending on marketing, new assets, research and development.

Researchers classified the companies and their responses into four groups:

  • Prevention-focused companies, which make primarily defensive moves and are more concerned than their rivals with avoiding losses and minimizing downside risks.
  • Promotion-focused companies, which invest more in offensive moves that provide upside benefits than their peers do.
  • Pragmatic companies, which combine defensive and offensive moves.
  • Progressive companies, which deploy the optimal combination of defence and offense.

Getting the balance right, being a ‘progressive company’ is a challenge we all face right now, particularly given the effects of recession are not felt for some time – for example, the depth of the 1987 recession was felt in 1991. So best practice means being prepared for the next waves as they come through.

So what does best practice look like? Here are some steps that can help:

  1. Continue monthly /quarterly rolling cashflow forecasts
  2. Preserve liquidity so you have two to three months working capital
  3. Regularly forecast sales so you can identify trigger points for actions
  4. Use a financial model to calculate
    • Sales by category or division
    • Gross margin before labour by same
    • Overheads
    • Direct and indirect Labour
    • Your breakeven under a best / worst / likely scenarios.
    • Note your breakeven can be quickly adjusted to a percentage of sales e.g. 10% target.

The model below determines your monthly salary cap. Determining your salary cap is the best way to achieve your required labour productivity and, for simplicity of explanation, I have used an annual example.

  • Assume revenue of $1 million and a net profit goal of 10% or $100,000
  • Assume also, we have non-salary costs (costs of goods sold $200,000 and overheads of $200,000) i.e. a total of $400,000.
  • We can now determine a salary cap of $500,000 in order to still achieve our net profit goal of $100,000 or 10% at this revenue.
  • It doesn’t matter if your employees are part-time or full-time. You have a $500,000 salary cap. It doesn’t matter if you give incentive pay or hourly pay. The sum of all salaries & wages at the end of the year cannot exceed $500,000. It’s no more complex than that.  On a monthly basis, this is $41,666.67.

Being able to respond to economic challenges takes some flexibility – for some years now, agile working has been signaled as a good way to operate but what does that mean for day-to-day operations? For the most part, it means continually reassessing your position – what matters most? Next, stay vigilant, inspect and take stock of your numbers. Work on your strategy – what choices are there, how can you improve your value proposition, what will you do to inspire your team? Finally – agile means getting on with the job. Executing and implementing the plan as you adjust it and often this is the hardest piece of the puzzle.

We may find ourselves in a great recession but with some forward thinking, agility and an adherence to best practice it is possible to come out the other side and flourish.

Author: <span>Gordon Stuart</span>