Wednesday, February 22, 2012

Factor #3 of 10: Cash


Working capital requirements

In the Self-Assessment, we asked you this question:

  1. We receive payment:
    1. in advance, before shipment and/or delivery.
    2. as a partial payment (a deposit) in advance before shipment or delivery.
    3. upon shipment and/or delivery.
    4. after invoicing, within 15-30 days.
    5. after invoicing, within 30-90 days.

For the business owner balancing cash flows and working capital can be one of the most challenging business problems. Cash flow and timing of positive cash flow is the life blood of a business.

Every business requires working capital. For accounting purposes working capital is defined as Current Assets minus Current Liabilities. In reality working capital is the cash flow required to sustain the business between the moment the product or service is offered, to the point in time where the customer’s payment enters the cash flow of the business. The working capital covers the Cost of Sales, the fixed cost and the variable cost for that interim time frame. There are a number of popular financial models to calculate working capital requirements.

A simple example for how a business is sold: In the case where the business only sells their assets (which indicates the business owner is still responsible for the liabilities), the Buyer uses those assets to create cash flow going forward. For this type of transaction the Buyer is responsible for the cash flow requirement or working capital to sustain the enterprise from day one to the point where the customer’s payments enter into their cash flow.  The Buyer provides their own working capital.

In the share sale model, most Buyers will expect to see some portion of working capital to remain in the company as part of the transaction. While the working capital calculations vary based on the cash flow model of the business, the business owner should be prepared in advance for this discussion.

The business owner will need to demonstrate the financial impact on cash flows for the type of service or product provided. This identifies the funds required to cover operating cost for time required until revenues/cash flows enter the business. The business owner who clearly models working capital requirements and timelines for cash flow demonstrates a business model which the Buyer can immediately understand. Buyers typically perceive a business with a clear working capital financial model as having a higher value because they are able to understand and model working capital requirements and avoid surprises.

TO DO:
  1. Review the timeline between the receipt of an order/sale and when payment typically received. (i.e. 60 days)
  2. Calculate cost/overheads/fixed variable expenses for that period to estimate working capital requirement.
  3. Look at your month by month cycle for the year and determine your minimum and maximum working capital requirement for your fiscal year. i.e.: In Summer may be busier than winter so more working capital is required.