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.
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.
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.
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.
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.
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.
A sudden slip into Alert Level Three, the blast of the emergency ‘COVID’ warning through our phones and once again we’re into the balancing act of keeping our businesses moving in exceptional circumstances.
Last month our Pulse Check results told us how adaptable and flexible New Zealand’s small business are, with business owners altering operations and changing practice in order to survive the challenges that 2020 has thrown at us all. Just as we have rolled out our August Pulse Check – which you can access here if you would like to participate – the beat has changed again and, in Auckland, we are facing at least three days at Level 3, probably more, with the rest of New Zealand parked up at Level 2 for the time being.
We asked our Auckland team for their thoughts on the current situation and their advice was simple — we’ve been here before, rely on past experience and know that it will pass.
The Alternative Board’s managing director Stephen James said: “Knowing it will pass, spend some time addressing a few scenarios. For example, if Level 3 lasts, as announced, for three days what do you need to do? Or, if it remains in place for two weeks or if Level 4 is declared and we have full lockdown for an indefinite period — what then? Develop plans of action for each scenario and communicate these to your staff and stakeholders.”
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:
Continue monthly /quarterly rolling cashflow forecasts
Preserve liquidity so you have two to three months working capital
Regularly forecast sales so you can identify trigger points for actions
Use a financial model to calculate
Sales by category or division
Gross margin before labour by same
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.