Working Capital Management: A must for any startup
9th February 2012 · 0 Comments
In any company, large or small, venture-backed or lifestyle, there is an inherent tradeoff between liquidity and profitability. Liquidity is the ability to meet your short-term obligations, like paying suppliers or making loan payments, while profitability is an accounting convention which indicates the value created by the business over a period of time, expressed as earnings. Large companies possess resources to help them manage this tradeoff such as an accounting department, negotiating power with their suppliers, or access to the capital markets. For the entrepreneur, however, who is often resource-starved and doesn’t have enough operating history to secure additional credit, managing this tradeoff can feel like walking a tightrope.
To illustrate the tradeoff between liquidity and profitability, consider the following example. Your new company has gained some traction in the market, and monthly revenues have remained steady over the past few months at $100K. Your operating margin is steady at 10%, meaning that each month your fixed and variable costs equate to $90K. You’ve just signed a customer who wants to test your product next month to the tune of $20K in additional sales, and if satisfied after the trial will triple his business with you. This represents huge growth potential for your fledgling company and is an exciting opportunity, but let’s take a look at the economics. With operating margins remaining at 10%, the $20K in sales equates to an additional $2K in operating profit, increasing your profitability. However, it also means you’ll have to spend an additional $18K on variable costs next month, and since you offered this new customer net 30 terms, you won’t see his payment until the following month. As a startup with little cash on hand, how will you finance that additional $18K in expenses next month, or triple that in future months if this new customer decides to increase his business with you?
Growth in sales requires a growth in assets, and specifically current assets. This is a direct relationship. For example, higher sales volume may be achieved only if production increases, and higher production rates require greater investment in inventories. Said another way, sales growth requires more working capital, or the cash used to fund day-to-day operations. Therefore, growth requires policies for working capital management, especially for the startup with limited resources, for which the difference between good and bad working capital management policies can be the difference between growth, or just plain survival, and bankruptcy.
A good metric for assessing your company’s working capital efficiency is the Cash Conversion Cycle (CCC). The CCC can be defined as the length of time between paying your expenses and receiving payment from your customers, or the number of days it takes to convert your company’s activities which require cash back into cash. Take a look at the following graphic, which shows one operating cycle and the resulting CCC:
After paying your suppliers, your company’s working capital, or cash, is tied up in inventory until you receive payment from your customers. The longer the CCC, the longer the company’s cash is tied up, and the greater the risk of being unable to meet other short-term obligations. Additionally, it is important to note that operating cycles often overlap, meaning that it is not certain you’ll be able to fund the current operating cycle with proceeds from the last operating cycle. This overlap often requires the company to fund additional operating cycles through some means of external financing like supplier credit, credit cards, or short-term loans. However, any form of external financing, whether debt or equity, bears some additional cost (like interest) which directly translates to the company’s bottom line. In periods of high growth, the effects of the CCC are exacerbated, and a startup can quickly deplete all of its available sources for external financing. Therefore, it behooves the entrepreneur to track his company’s CCC and try to minimize its effects to the extent possible.
To calculate your CCC, use the following formula:
CCC = DIO + DSO – DPO
Where:
DIO = Days Inventory Outstanding
DSO = Days Sales Outstanding
DPO = Days Payables Outstanding
To calculate DIO, DSO, and DPO you’ll need some information from your financial statements:
For the average inventory amount (or receivables/payables), calculate the average between inventory this period and last period:
Most companies have a positive CCC, but there are some, like Dell, which have a negative CCC. Dell accomplishes this largely because it has the negotiating power to be able to delay payments to suppliers (long DPO), but it also employs business practices like just-in-time inventories (shorter DIO) and built-to-order production (shorter DSO) which reduces its CCC and frees up cash within the business. More important to note in Dell’s case, however, is that the company’s business model was designed to intentionally minimize the CCC and maximize the amount of cash available to fund the company’s operations.
Take a look at your business model – are there missed opportunities to shorten your CCC? Are there ways to redesign the business model to free up more cash? If not, are there other areas where your working capital could be managed more efficiently? The answers to these questions are different for each business, but in the end, an effective and efficient policy towards working capital management can greatly facilitate your ability to walk the fine line between liquidity and profitability.
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