You are currently browsing the category archive for the ‘small business’ category.
It takes money to make money. All businessmen know that. The most fundamental explanation is the Cash Cycle or the Cash Conversion Cycle. When thinking about your company, understanding how quickly you turn cash outflows into cash inflows is as important as how much profit you are booking. This is one of the first metrics I check when I’m hunting for understanding of a business. Today, we’ll see how it applies to a manufacturer I looked at the other day and a distributor that is one of our clients.
Let’s break this down We measure how swiftly a company turns cash into goods or services and back into cash. To do this, compute the cash conversion cycle, or CCC.
CCC = DIO + DSO – DPO where:
DIO = days inventory outstanding
DSO = days sales outstanding
DPO = days payable outstanding
DIO = 365*Average Inventory/COGS. Days inventory outstanding is how many days it takes to sell inventory. Shorter is better. The more quickly a company can sell its inventory, the less time that cash is tied up as inventory sitting in the warehouse.
DSO = 365*Average Accounts Receivables/Revenue. Days sales outstanding is how many days it takes to collect accounts receivable. Shorter is better. Quickly collecting the cash for sales means more quickly putting that cash back to work rather than lending it out to its customers (at 0% interest).
DPO = 365*Average Accounts Payable/COGS. Days payables outstanding is how many days it takes the company to pay the bills to its suppliers. Longer is better. That is, extending payment of accounts payable acts as an interest-free loan to the company and keeps more cash within the company – until they quit extending terms.
Why does the CCC matter? The less time it takes a firm to convert outgoing cash into incoming cash, the less cash you need to run the profit engine. The less money tied up in inventory and accounts receivable, the more available to grow the company, pay investors, or both. To calculate the cash conversion cycle, add ‘days inventory outstanding’ to ‘days sales outstanding’, then subtract ‘days payable outstanding’. Like golf, the lower your score here, the better.
Example: a small distributor
| Cash Conversion Cycle | |||
| Period 1 | Period 2 | Period 3 | |
| DIO | 1.04 | 0.00 | 0.00 |
| DSO | 51.27 | 67.19 | 33.57 |
| DPO | 57.09 | 64.53 | 33.52 |
| CCC | -4.78 | 2.66 | 0.04 |
You can see that, as with most distributors, their cash cycle is balanced as they negotiate terms with their suppliers that let them pay for goods about the time they are able to collect on sales. They’ve pretty much averaged zero days cash conversion over these three periods. In that way they avoid needing large amounts of cash to support their profit engine.
For most small businesses, the CCC can give you valuable insight into how much cash is needed to sustain the business, where it is coming from, and whether or not that is a suitable place. It will also tell you how long it takes to turn a profit into cash. A company that’s taking longer to make cash will need to tap financing to grow faster than its profit reinvestment allows.
Many companies have poor basic capital structures where there is no real source of financing for the needed cash to operate the business, and this needs to be corrected.
Example: a small manufacturer
| Cash Conversion Cycle | |||
| Period 1 | Period 2 | Period 3 | |
| DIO | 299.10 | 375.04 | 525.18 |
| DSO | 175.03 | 33.17 | 24.72 |
| DPO | 171.76 | 210.53 | 312.80 |
| CCC | 302.38 | 197.68 | 237.10 |
This firm needs to do work on its policies and operations. Its position improved somewhat over the three time periods, but it still needs to have 237 times its average daily revenue in cash to finance its operation! Mostly this is due to excessively large inventories that are being financed on the back of paying its suppliers very slowly – almost a year on average! – and collecting from its clients very quickly. One look at this would lead us to go look at the inventory to see if it is still useful or if they’ve accumulated a bunch of inventory that will have to be thrown away.
For other firms, especially firms under duress, the CCC can tell you how well the company is managed or, at least, the degree of distress. Firms that begin to lose control of the CCC may be losing their clout with their suppliers (who might be demanding stricter payment terms) and customers (who might be demanding more generous terms). This is an important signal of future heightened distress — one that is key to investors and lenders.
How much capital do I need to operate my Cash Cycle?
You must have come up with the cash to pay for the inventory not when it is delivered, but when the invoice is due. Normally this is 30 days after delivery, but specific to the terms you negotiated with your supplier. Then, to the extent those terms are sooner than it turns into a sale (i.e. DIO > DPO), you need to finance your cost of inventory per day for that number of days. Additionally, you need to finance your receivables balance for the duration it is outstanding.
Where does it come from
Mostly, you’ve built this up from the original investment in the business, and accumulated profits. Conversely, you can borrow against your receivables and inventory assets (on the balance sheet) to finance them. This financing is called a working capital line of credit, or factoring.
What change over time tells me
For a firm in distress or need of capital, I’m highly interested in comparing a company’s CCC to its prior performance. Here’s where I believe all owners, managers, investors, and lenders need to become trend-watchers. Sure, there may be legitimate reasons for an increase in the CCC, but all things being equal, I want to see this number stay steady or move downward over time. Because of the seasonality in some businesses, the CCC for the TTM period may not be strictly comparable to other fiscal periods. Even the steadiest-looking businesses on an annual basis will experience some quarterly fluctuations in the CCC.
Though the CCC is easy to calculate, it’s definitely worth watching every quarter. You’ll be better informed about potential problems, and you’ll improve your odds of finding the right capital structure for your business.
If you want to get really sophisticated, you can add the amount tied up in property, plant and equipment, call that tangible capital employed, set it as the denominator under profit, and see what returns you are earning on the capital you have tied up in the business. Perhaps you’ll find you’d be better off buying a Treasury bond and sitting on the beach.
Cash is King. Profit numbers live in the accounting fantasy world we call “earnings” and have all sorts of things in them. Understand where your cash is coming from and what it is being consumed by and you’ll be a long way down the path of being able to keep some of it for yourself.
Let’s face it, cash is king. As a business owner, you know it is in your best interest to collect outstanding receivables as quickly as possible. Quickly turning sales into cash allows you to put the cash to use again to reinvest and make more sales. So which accounting calculation is your friend in helping you see if you are being effective at bringing money in? DSO or Days Sales Outstanding is the most widely used measure of back office efficiency by credit executives.
Without boring you like Charlie Brown’s teacher, I will explain why knowing it can ultimately help you improve your cash flow in the future and, then, let’s get to the meat of how this little equation works.
Why do you care about DSO?
When used consistently, this calculation can help you answer a variety of questions such as:
- What is the effectiveness of my credit and collection policies?
- Are my credit terms in line with competitors? The Credit Research Foundation (CRF) does a quarterly study, the National Summary of Domestic Trade Receivables (a.k.a., the DSO Survey), that is an examination of the condition of AR for U.S. companies. The results of the complete study are available to CRF members and those participating in the survey.
- Are my collections procedures successful in meeting my goals?
- Is my customer base risky?
- What is the real reason for the changes within my receivable balance? Was it a fluctuation in sales during that period, or are promotional discounts, seasonality or selling terms making the impact?
Unleash the DSO.
Days Sales Outstanding expresses the average time, in days, it takes your company to convert its accounts receivables into cash. There are several ways to calculate DSO. Each method for calculating DSO (outlined below) has its own strengths, and each is based on what might be called the Standard DSO formula. The key to making effective use of any of these tools is consistency. Select the method s that work best for you and stick with them.
- The Standard DSO calculation provides an average (aggregate) time in days it takes to convert accounts receivables into cash. It should be tracked over time and compared to previous company results or industry/competitor benchmarks
DSO = (Ending Total Receivables / Total Credit Sales) x Number of Days in Period
- Best Possible DSO utilizes only your current (non-delinquent) receivables to calculate the best length of time you can achieve in turning over receivables. It should be compared to the standard calculation above, and be close to your terms of sale. The closer your standard DSO is to your best possible DSO, the closer your receivables are to your optimal level.
Best DSO = (Current Receivables / Total Credit Sales) x Number of Days
- True DSO calculates the actual number of days credit sales are unpaid by tracking individual invoices to the month of sale.
True DSO = (invoice amount / net credit sales for the month in which the sale occurred) x number of days from invoice date to reporting date
Of course, if your DSO shows it is time to reign in those receivables, there are several strategic ways to go about this. We’ll delve into that next week . . . to be continued . . .
I’ve been following this week’s press on the proposed tax plans for small businesses. Two prongs of the plan to provide $35B in tax cuts for small businesses and workers were under fire in this morning’s edition of The Wall Street Journal: 1) increasing, for 2010 and 2011, the write-off for qualifying equipment to 100%–a two-year cut, and 2) making the tax credit for business-research expenses permanent.
Today’s articles highlighted some of the issues small businesses struggle with as they contemplate how these proposed cuts could help them lower the 9.6% unemployment rate the country is facing. Assessing the net impact of any tax cut or increase is difficult at best, and consumer and business confidence is much of what helps to boost the economy. Knowing that you won’t have to spend additional money on taxes, or that you might even spend less, can give you the confidence to project your revenues and expenses, and thus to assess growth opportunities and the hiring of additional employees.
As far as the proposed cuts go, businesses spending less than $800K on certain equipment can already write-off up to $250K, which means many small businesses are already taking advantage of this write-off. It appears to be a two-year tax cut targeted at a very small number of businesses: those making over $800K in either manufacturing or an industry that must constantly re-invest in new equipment. While manufacturing as a whole comprises almost 12% of employment, it represents only 5% of all establishments, most of whom are large companies.
If this write-off is an attempt to encourage spending through the purchase of new equipment (which could have a net positive, short-term impact), what is the reality of a small business having the funds to make such a purchase? Investing in capital equipment requires a cash investment no matter how quickly it can be written off. Most small businesses simply don’t have access to the cash required for these purchases, and, even if they do, most are already with the qualifying $250K limit. Is a tax credit with a two-year limit really just a quick shot of adrenaline versus a boost that will provide a long-lasting impact to the majority of small businesses, the fabric of our economy?
Making the credit for research expenses permanent is a longer-term fix, but it requires the ability to see ahead and invest in the future in a time when many small businesses are struggling to make it from one day to the next.
What would you propose? What tax relief would help you expand your business and help reduce the unemployment rate?
WSJ: Obama Tax Plan Holds Less for Small Business http://online.wsj.com/article/SB10001424052748704358904575478053722103156.html
Parties Spar Over Small-Business Proposal http://online.wsj.com/article/SB10001424052748703417104575473653330146646.html
Kelli Spencer is a product marketing professional. Ftrans combines professional receivables services with fast and affordable access to funding – providing small and medium businesses the cash they need to grow and take advantage of market opportunities. Liberating you from funding challenges and receivables hassles.
As part of our ongoing series on small business funding, I sat down with Dave Price, whose firm, Bennett Design and Landscape, is a nationally recognized landscape architecture firm and a fixture in the Atlanta landscape design scene. He shared with me his personal observations and described his experience applying for an SBA loan.
Your story is a classic start-from-scratch American small business story. Can you share a little bit about how you went from not having a business to a $5 million business with 13 employees a few years later?
My partner and I both had full time jobs. He was a landscape architect and we thought why not make some money on the side designing and installing small landscape projects for homeowners? We soon realized that once we earned our customer’s trust on the small jobs it quickly went to, “I need a new driveway or retaining wall.” Within a year we thought we had enough business for one of us full time and a small office in the basement. A year and a half later we had an office manager, and a couple of employees and we were both working in the business full time.
Whenever owners of small or start-up businesses ask around about financing they are often advised to look into an SBA loan. When you started thinking about getting an SBA loan, how did you research the process and how did you get started?
Around that time we already had a $60,000 working capital line of credit and an additional $15,000 line of credit secured by our building, plus a HELOC on my home. We knew nothing about SBA loans. We already had depository and lending relationships with a couple of Tier 1 banks so we started there. They explained the process to us, looked at our P&Ls and Balance Sheet and gave us packets outlining the process step-by-step.
With your existing lines of credit, you had already been through the underwriting process before. What was different about applying for an SBA loan?
The level of paperwork involved. We learned it wasn’t just a lot of paperwork for us; it was a lot of paperwork for the bank too. We also had a misconception. We thought, here was the SBA with a pile of government money to help small businesses to grow the economy. We found out that the banks are really lending their own money and the government was just acting more like the FDIC, as a back up.
The bank was much pickier than for a standard line of credit. The SBA wanted to know specifically how you were going to use the money and how it was going to impact your business. In the end, both banks told us this is going to be a mess. It’s going take a lot of your time and your chances of getting approved for the loan are maybe 30%. We were bankable but weren’t nicely fitting into the criteria. They explained that we were not a minority or female owned business. We weren’t doing work for the government.
To come – Part 2: That’s not the end of the story though. You tried again!
This post is part of a series on funding small and medium sized businesses; first-hand accounts from people who have been through it from knocking down SBA loan hurtles, to how venture capitalists and private equity partners think, to what’s new in getting an old school line of credit.
Dave Price started his landscaping design and architecture firm in Atlanta with a $100 investment. Fourteen years and several local and national awards later, Bennett Design & Landscape’s designs have been featured in Southern Living and Atlanta Homes & Lifestyles.
Sandra Chesnutt is a Marketing Senior Manager with Ftrans. Ftrans combines outsourced accounts receivable management with fast and affordable access to funding – providing small and medium businesses the cash they need to grow and take advantage of market opportunities.
For businesses seeking small business loans or working capital loans, the process may seem like a Catch-22, or no-win situation. Generally, loans are secured by collateral such as accounts receivable, inventory, real estate, and other assets. But, according to the Wall Street Journal’s article, Collateral Damage in Lending, the collapsing value of assets such as inventory and equipment is causing a collateral gap and resulting in many businesses falling short of loan eligibility. Thus, these small businesses must still pledge the usual collateral, but, increasingly, small business lenders are requiring cash or other highly liquid assets as secondary sources of repayment. The Catch-22 is that often these cash requirements are equal to the loan request amount. As a result, small business owners find themselves asking, rhetorically, “If I have the cash, why do I need the loan?”
Accounts receivable remain one of the most important assets of a company. They are the primary generator of cash. Tighten and reduce your cash conversion cycle by reducing your business’s accounts receivable days outstanding to generate more cash. To do this, consider your business’s complete revenue cycle from customer acquisition to invoicing to payment receipt. Is your business following accounts receivable best practices? What is the propensity to pay and credit worthiness of your customers? How does the business handle aging receivables?
Companies such as Ftrans offer complete accounts relievable and credit management solutions that help businesses address cash and revenue cycle concerns. Implementing these best practices enables accounts receivable funding for your business without a Catch-22.
