Working Capital: How is it working for your business?
Unfortunately, few multiple-unit franchisees or managers fully understand working capital, how important it is for every business, how it is measured, or how to obtain needed working capital.
To many business owners and managers, working capital is simply the cash they have on hand to pay their bills. Others understand that working capital is more than just cash - that it includes accounts receivable, inventory, and other current assets of their operation.
By definition, working capital is simply the amount by which the business operation's current assets exceed its current liabilities. Too little working capital means the business will soon be unable to pay its bills. Too much working capital means the operation is passing up the opportunity to put excess working capital to work elsewhere in the business, or to invest those excess funds elsewhere to produce extra income for the business.
Working capital and liquidity
Liquidity exists when a business operation can satisfy its maturing short-term debt. Liquidity is important in carrying out any business activity, especially in times of adversity, such as when a business is shut down by a strike; or when operating losses result from a recession or a significant rise in the price of goods, products, or supplies.
If liquidity is inadequate to cushion such losses, serious financial problems may ensue. Poor liquidity can best be compared to a person having a fever: it is a symptom of a fundamental problem. It is also a problem that can spread from one franchise unit to all, thereby affecting the entire operation.
The liquidity of a business is particularly important to creditors. If a franchise unit (or the multiunit franchise operation itself) has a poor liquidity position, creditors may see this as raising questions about the business's ability to make timely interest and principal payments, causing them to view the business as a poor credit risk. This also can result in increased borrowing costs. Thus, measuring the liquidity of the business is an essential element when analyzing a business operation's working capital requirements now and in the future.
The working capital of any business is a safety cushion to creditors. A higher balance would be needed when the business has a problem borrowing on short notice. As mentioned, an excessive amount of working capital may be bad because those funds could be invested in non-current assets for a greater return.
Working capital is measured using the formula:
Working capital = current assets - current liabilities
For example, suppose Joe's Franchise Group shows current assets (cash, accounts receivable, inventory, etc.) for the current year of $120,000. Subtract the $55,400 amount of the operation's current liabilities and he has working capital of $64,600.
Note: Even a slight increase in the current amount of working capital over the last accounting period is a good sign.
Analyzing working capital
If any franchisee performs that calculation (current assets - current liabilities) to arrive at the amount of working capital in either a unit or in the entire operation, not much will be accomplished insofar as determining the operation's future working capital needs and how to meet them. Thus, the need to analyze the operation's working capital position.
A useful tool employed by many business owners and managers as a part of that analysis is the operating cycle. The operating cycle analyzes the accounts receivable, inventory, and accounts payable in terms of days. In other words, accounts receivable are analyzed by the average number of days it takes to collect an account.
Inventory is analyzed by the average number of days that it takes to turn over the sale of a product (from the point it comes in the door to the point it is converted into cash or an account receivable).
Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice.
Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, more working capital is often needed. Most businesses will need short-term working capital at some point.
Retailers, for instance, must find working capital to fund seasonal inventory build-up between September and November for year-end holiday sales. Even a franchised business that is not seasonal occasionally experiences peak months when sales are unusually high. This creates a need for working capital to fund the resulting buildup in inventory and accounts receivable.
Some businesses have enough cash reserves to fund seasonal working capital needs, but that is rare. If your business, like the majority of multiunit franchise operations, experiences a need for short-term working capital, several potential funding sources exist. The most important thing is to plan ahead. To be caught off guard may mean missing out on a big order, a big sale, or a great one-time opportunity.
Here are four of the most common sources of short-term working capital:
Equity. Many businesses must rely on equity funds for short-term capital needs. These funds might be injected from the owner's personal resources or from a family member, friend, or third party.
Trade credit. A franchisee, business owner, or manager who has established a good relationship with trade creditors may be able to solicit their help in providing short-term working capital. A business that has paid on time in the past may be able to negotiate extended terms to help the operation meet a big order.
Line of credit. Lines of credit are given to well-capitalized, well-run businesses that show promise. A line of credit allows the business (or its units) to borrow funds for short-term needs as they arise. The funds are repaid once the business collects the accounts receivable that resulted from the short-term sales peak. Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only.
Short-term loans. Although not every business can qualify for a line of credit from a bank, it might be successful in obtaining a one-time short-term loan (less than a year) to finance any projected temporary working capital needs. A franchise or multiunit business that has established a good banking relationship might be able to benefit from a short-term note for on order or for seasonal inventory and/or accounts receivable buildup.
The importance of working capital
The financial information of every business is summarized on three key accounting statements provided by the operation's bookkeeper, accountant, or computer bookkeeping system: 1) the balance sheet, 2) the income statement, and the 3) statement of changes in financial position.
- The balance sheet can be best described as a photograph showing the assets, liabilities, and owner's equity in the business at one point in time.
- The income statement can be thought of as a motion picture designed to show the profitability of an operation over a period such as a quarter or a year. By subtracting expenses from income, the income statement reveals the amount of profit (or loss) for that accounting period.
- The statement of changes in financial position explains the financial changes that occur from one accounting period to the next. It focuses on the sources and uses of funds in the business.
The so-called statement of changes in financial position, which is of more recent origin than the income statement and the balance sheet, is required for almost all publicly traded companies. Since 1970, the Securities and Exchange Commission has required this statement as part of the annual registration information for all companies listed on organized stock exchanges. It must also be included as part of the accounting information for firms whose financial statements are audited by public accounting firms.
As its name indicates, the statement of changes in financial position is designed to explain the financial changes that occur in a business from one period to the next. It is sometimes referred to as the "where got, where gone" statement because it presents the financing and inventory activities of the operation from one operating period to the next.
The statement of changes in financial position reflects the franchise or multiunit operating entity's ability to meet its operating expenses and to purchase additional merchandise for resale. The focus of this statement is on increases or decreases in working capital (the difference between current assets and current liabilities). In effect, working capital represents the source of assets to keep the business operating during the months ahead.
It should be obvious by now that working capital has a direct impact on the cash flow of any business. Since cash flow is the name of the game for all business owners and managers, a good understanding of working capital is imperative to make any venture successful.
Mark E. Battersby is a freelance writer, author, columnist, lecturer, and consultant specializing in taxes and finance for more than 30 years.
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