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Let Your Working Capital Work For You

Rule #1 in business - Don't run out of money

If you’re running a business, you need working capital.

If you don’t have working capital, you’re out of money.

If you're out of money, you broke Rule #1.

Working Capital is defined as a business' current assets less current liabilities.

What does that mean?

The real definition of working capital is, "can you pay all your bills and live to fight another day in business, or do you need to call capital or shut your doors?"

Businesses choose to raise capital or obtain lines of credit because it is tough to scale profitably. It is even tougher to scale without running out of money.

The way you set up your business from the beginning can make a huge impact on how far you can scale without running into a cash crunch.

Two stories about two very different businesses

Kevin owns and operates his own IT firm. He worked for a big firm out of school, and always wanted to go out on his own and 'be his own boss'.

Kevin has five employees and makes $1.3 million in annual revenue, netting $380k before taxes.

Kevin is making a good living and his business is growing like a weed. There is one issue: Kevin never has any money, and his bank lines are completely maxed out.

He is always robbing Peter to pay Paul. There is never a shortage of new clients, but there is always a shortage of cash at the end of the month.

Susan owns a digital design company. Coincidentally she has the same number of employees, grosses the same amount of money each year, and her business also nets $380k before taxes. Weird, right?

An odd thing is that Susan's business always has more money than it even needs. She takes a $150k salary and is distributing a $250k bonus next month of accumulated profits from the last year.

The difference between these two companies is cash flow. Both of these companies make the same amount of money. But one is flourishing while the other is floundering.

Let me explain what’s causing such a drastic, completely avoidable difference.

Kevin

Although Kevin’s business has been growing and adding new clients, his broken process has destroyed his company’s cash flow.

Kevin’s company struggles with billing. As they get busy managing day-to-day tasks and putting out fires, billing always seems to gets pushed to the back burner.

Oftentimes, Kevin doesn’t even invoice until the next month.

Because of this, once Kevin has counted his time, invoiced his clients and finally collected one to two months later, up to four months may have passed since the client was originally signed and the work was performed.

Kevin has to pay his contractors and employees every 2 weeks for the work they have completed the week before. He has one week of 'float', and is providing his clients up to 16 weeks of float!

30 days of work, 30 days to bill, 60 days to collect. What a nightmare!

Susan

Susan’s company takes a bit longer to complete their client's work after signing them on, taking up to 60 days to complete every part of their website design package. However, Susan collects 50% a retainer upfront and charges an ongoing service fee for her clients each month.

Her revenue cycle couldn't be any different than Kevin's!

Since Susan takes a retainer up front and collects monthly recurring revenue, she has a Negative Working Capital Cycle. At the beginning of the project and the beginning of each month, she owes money to her clients, not the other way around.

Susan doesn't face collection issues - she keeps her client's card on file and bills according to their engagement letter. As her business grows, so does her company’s working capital liability. This allows her to stay ahead and hire additional staff based on her growth.

Apart from the peace of mind that comes with this approach, there are also tax advantages to structuring your business this way. For example, a retainer is not recognized as revenue; instead, it is considered a deferred revenue liability. The cash is not earned until the work is performed — it is essentially a loan from the customer to the business.

Susan's biggest risk is that she does have a liability to her clients. She needs to complete the work in a timely, satisfactory manner.

Consider this recommendation: Don’t be like Kevin — borrowing money from a bank to loan money to your customers and pay your bills.

Rather, be like Susan — have your customers loan you money to fund your company’s growth.

Having capital can change the trajectory of your company and allow for continued revenue and growth.

Don’t run out of money.

Until next time,

Mitchell

P.S. If you made it this far and enjoyed what you read, send this to a friend who might like it!

P.P.S. My friend Scott Hambrick and I have been working on a podcast! It’s called Stupid Tax - covering taxes, small businesses, and a whole lot more. Episode 1 kicks off this week!