Where do we get operating capital and what should it cost?
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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 email list. Email subscribers always get my latest videos first. Thanks.