Working capital gap

“Sales are growing but I have no cash to order new products”, “We have contracts with big organisations but we could not cover salaries”, “We need another loan, the landlord called again for the bounced cheques”…How many times we hear this from small companies having great ideas and customers knocking at their door? Business failures could present several causes for which lack of capital is one very common. The Gulf region with its oil and gas resources present a high revenue per capita facilitating the injection of capital. However the problem is precisely not a lack of funds available but an inadequation of the equity allocated to fuel the specific business. A typical issue of successful businesses failing is the underestimation of working capital needs to run the operations.Working capital remains an abstract concept for people who see accounting as an annoying mystery, being the amount of cash required to transform a service or product until it become cash again. We buy materials, pay rent, salaries, produce a good or sell a service until the funds paid by the customer acquiring our good or service are transferred into the company’s bank accounts. This cash need is strongly increased when customers have a long time to pay or the company requires a high amount of inventories to perform its activity. On the other hand, this cash need is relieved when suppliers allow longer payment terms to the company, funding indirectly part of its operations. A key element to increase the performance of a business is by optimising its working capital needs: looking to sell with an upfront payment or shorter delays providing a discount, minimising the amount of inventory provided that the risk of rupture of stock or spare parts unavailability remains manageable or capitalising on supplier longer payment terms.This clearly depends on the context of each business, what competitors offer at customer or supplier level and on the strategy of the company. Working Capital optimisation remains mainly applied on more mature businesses while a general manager of a new business or start-up is running behind the customers and for good reasons will not even think to listen to its finance manager to optimise this untangible but painful financial element. That brings us to the roots of the business and how important it is to evaluate conservatively the working capital needs and allocate the required capital before starting the machine and say hello to the first customer.The most common mistakes for companies starting business in terms of working capital evaluation are:1) Not allocating a single QR to a working capital need, thinking the only investment required is the purchase of the fixed assets and the payment of the first month’s of salary: “I have already people interested in my product, why we will not get the sales?” 2) More conservative approach, in addition of the amount of fixed assets and other investments, to allocate capital to fund a working capital need based on a rule of thumb of six months of the operating result being the revenues minus operating expenses (not including any non-cash expense as the depreciation). That sounds right….. but the conservative rule of thumb come from markets where customers pay at 30-45 days and do not have practice of forgetting payments, leaving the business with no cushion.3) Foolproof solution, funding the total amount of working capital but… with a bank loan. In this case we take the measures to finance the total working capital but we increase dramatically the risk of the business. The working capital remain a permanent cash need during the whole life of the business, while the loan has a specific expiry date and fixed reimbursements, which is not compatible: Someday we need to pay also the bank no?So what to do? There are no magical solutions to that, just to apply common sense, evaluate closely the cycle and cash needs of the business and to be prudent/realistic without to compromise taking an adequate level of business risk. Ideally, to build the business evaluation in a simple calculation sheet where few tests could be done to measure the potential working capital needs based on more conservative or stressful business assumptions and projections.Clearly the proposal is not to over-invest and fund as much as possible in equity which would impact strongly the expected return on investment. The objective is just to take the measures and plan the necessary cash that could be required, avoiding running out of cash suddenly or calling urgently all investors to inject again capital unexpectedly in the company (Investors do not like surprises…). The total amount of equity could be calculated and agreed with shareholders in advance and just to call the necessary cash having an option to call for any additional amount based on the total capital authorised. Once the company is running, the seasonal working capital peaks could be optimised recurring to bank loans, being a complement to the equity already injected and funding the permanent working capital.Next time you will open a business think what would happen if your customer forget to pay or your materials costs increase suddenly: do not let your good idea stop working because of lack of capital.Yanick Latil is managing partner of Y&S Consulting LLP.