“If the people knew how hard I had to work to gain my mastery, it wouldn't seem wonderful at all.” --Michelangelo
These days, one of the things I hear most often in my conversations with CEOs is their confidence that growing revenue and reduced expenses is all that’s needed to restore performance and financial stability. That’s the simple cure to overcome the travails of the last 18 months. “If we can just get back some of the sales we’ve lost and hold down our expenses, we'll be profitable again and have the cash flow necessary to resume normal operations.”
Unfortunately, that scenario is unlikely to unfold as scripted. As a result of depleted profits and depressed cash flow incurred over the last 18 months, the financial resources to support revenue growth are at the lowest level in years. What business leaders regularly overlook is that pressure on working capital resources to support renewed sales growth is more crippling in times of growth than in periods of decline. This is exacerbated when business executives equate improved profitability with enhanced cash flow.
Let's assume you have a $10 million revenue business with receivables outstanding for an average of 60 days. That means that there is approximately $1.7 million in accounts receivable outstanding at any one time, representing approximately 15 percent of revenue. So, if revenue rises 10 percent and nothing changes in the accounts receivable cycle, accounts receivable will also grow by 10 percent or approximately $170,000. The growth in revenue won’t fund that need – it’s that growth that creates the increase. What resources will carry you while you wait those 60 days to collect the new receivables?
On top of that, you’ll need more inventory to fulfill those additional sales, always the most perilous component of working capital. While accounts receivable will grow as sales are made, inventory will have to grow before sales are made, and as we know, selling inventory in the planned timeframe is about as certain as medieval alchemy.
Again, where do the financial resources come from to support this growth? With the continuing restraint in bank lending resulting from more rigorous oversight by federal regulators as well as the reduced creditworthiness of business borrowers, obtaining those funds will be more challenging than ever. Lenders also know that very few borrowers truly understand their working capital requirements or the full measure of their external financing requirements. Business owners often adopt the shopworn approach of asking for a line of credit greater than they think they’ll require to open the discussions, figuring they’ll ultimately end up with what they really need. Without an objective analysis of the financing needs, this is a sketchy approach that may leave you deep in the weeds at the most inopportune time.
The first thing to do is to figure out your external financing requirements and compare them to the existing resources available to support working capital growth. The level of resources available for working capital is generally based on the company’s ability to earn profits and retain them in the business. The chart here illustrates a comparison of the external financing requirements to available financial resources using the same amalgam of U.S. companies we visited last time. When a significant gap occurs, as illustrated in the chart, the company can expect enormous pressure on its cash resources.