Working Capital: What is it?

Understanding working capital is essential for running a successful business. In this episode, we break down what working capital is, how it impacts your company's operations, and why it's more than just cash in the bank. From real-life examples to practical tips for managing accounts receivable, inventory, and payables, this discussion highlights how working capital acts as the 'fuel' that keeps your business moving. Tune in to gain insights on improving cash flow and setting your company up for long-term success.

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TRANSCRIPT

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has

partnered with small business owners to prepare for and navigate the business

transaction process. Pull up a chair as we share stories and insights from our

experience on all sides of the M &A table. All right, and welcome back to another

episode. I'm here today with Grant and Andrew from ICCG.

Today, we're going to be talking about what is working capital. So we're going to

go a little bit into working capital next two episodes. This one, we're going to

focus on what working capital is and what it looks like in business or in

companies. And then the next episode, we're going to talk about working capital and

action. So to get started, Grant Grant, Andrew, what is working capital?

- Yeah, look, if you're wondering why I have a smile on my face is because we're

talking to actually, what most people think is a bean counter concept

and in reality, it's a management tool. And so I've got a smile on my face because

we have this conversation so many times in our office as well as when we're talking

to clients, because it's probably the one thing that's deemed sort of almost

mystical, but the reality of it is it's such a great tool to use in managing a

business. So we'll have fun defining it, but it's going to be different for every

single company, but it's basically current assets, less current liabilities. So when

we're talking about working capital, it's really a net number. It's not a,

it's certainly not just cash. You know, a lot of, a lot of business owners think

it's just cash, but it's cash plus accounts receivable plus inventory and impossibly

some other current assets but then minus your accounts payable or accrued liabilities

if you want to get a little more technical. So it is the things that turn into

cash or use cash all the time in your business. That's working capital.

And so what is that for? So you talked, you talked a little bit about the kind of

the equation of working capital. How would you define that? Like what is, what is

important about it? Yeah, you know, If I have cash in the bank,

I can spend it, right? I can spend it, but in the meantime, I've got to collect a

count receivable in order to spend money after that, right?

And so if I have a very poor month of collections,

but I'm carrying on billing my clients, My account receivable is going to go up,

but my cash is not. But I still have account receivable. People still owe me money.

And the question is, have I paid my bills? Or are the bills piling up at the same

time as well? And so I think the biggest way I can-- or the best way I can

explain it is just recently, I read an article that it was by a P group and they

were measuring the ability of a company to convert net income to cash.

In other words, over the years and years and years I was a CPA, my clients would

say, "What do you mean I made that much money? Where did it go?" You know? Because

they reinvested the money in the business. They bought equipment or they paid off

debt or they did something with it. They distributed it to them.

But in a sort of a closed vacuum, you've got net income,

let's say, of a million dollars and at least 80 % to 90 % of that should go into

cash, right, eventually, at least. And so it gives you the ability or the muscle to

then go and either distribute the money or invest it in your business.

And so it's just the muscle that drives your company forward.

So basically what you need in the company to Keep operating. That's awesome Hey,

would you I know I know we've we've kind of even said before we kind of relate it

to a car, right? I mean, it's it's it's the gas and and even even the I mean,

it's it's the quality of the tires That's it's just the the what gets the the the

vehicle moving, right? And that that the way that we've described before Yeah,

I mean if you if you don't any gas in the truck, the truck can't run the call or

deliver the package. And so, you've got to have gas in the truck.

And so, working capital is that gas. It's cash in the bank, it's inventory that you

get to sell, it's accounts receivable that you get to collect and spend the money

on more purchases or on labor or those kinds of But can you give an example,

a simple example of what working capital, a working capital calculation would look

like in a business? So you mentioned that inventory, cash, those things, just kind

of add those together and play that formulation through. Yeah. So before I do,

let me just tell you something. In accounting, it's better to

Then can be then to be inconsistently right in other words if you define the

calculation of working capital one way then keep on doing that one way right and

the trends in that working capital will matter a lot to your management of your

business so that the normal way would be cash.

Plus accounts receivable plus inventory, minus accounts payable and that net number

is, you know, if you're looking at your financial statements, you look at current

assets that's at the top and then current liabilities and you go current assets

minus current liabilities, that technically is working capital, but a lot of people

don't account for crude labor or, you know, some things that, you know,

like I said, I mean, if you want to be technically correct, that's great. If you

have the accounting personnel to be technically correct, it's current assets less

current liabilities. But most people don't, on a monthly basis, they don't,

you know, do some of the accruals that are necessary for it to be general accepted

accounting principles.

So before the call, play that out a little bit further. Before the call, you were

talking about the difference between a residential plumber and a multifamily plumber,

and how that can look different. Andrew, you'll remember when we dealt with a large

plumbing company in the Northwest that dealt with multifamily construction.

So they weren't the guy that you called every to come unplug your drain. These guys

actually did all of the construction, the plumbing part of the construction for

apartment communities. And so they had a lot of labor.

It's more of a construction type company, so their account receivable had retainage

in there. And so he had to have a lot of working capital in order to sustain his

business, in order to keep on paying payroll, keep on buying supplies, those kinds

of things. And so you contrast that with your normal unplug my drain kind of

plumbing, the sort of the retail kind of plumbing, well, they don't need much of

working capital at all. All they need is the amount of gas they need in order to

get to where they need to go unplug a drain because they're going to get paid

right away, right? And then that labor is probably going to be a function of

whatever that guy just earned, and so your revenue model doesn't need a whole lot

of working capital. You might need some money maybe for repairing the truck every

night again. You might need some money to stock the truck with the supplies that

they generally need with the tools, those kinds of things, but it's not like you

are waiting 90 days to get your money But there's very little need for working

capital in it in a sort of a In a scenario where there's not it's just service

home service business

Yeah, because you don't you don't want to shut down your business for 90 days while

you wait to get paid, right? You got to keep on actually exactly for sure. That's

great So what are some companies the businesses can use to improve their working

capital position? The one that most people go after first is to collect accounts

receivable faster, right? So you change the terms for your customers until you get

this large customer that bullies you, right? So I'll give you multi -million dollar

deal, but you're going to have to wait 120 days to get your money. When you're

dealing with school districts, for example, we brought that up with a roofing company

just not too long ago, you're waiting 120 days to get your money. Well, you got to

pay payroll for 120 days before you-- even you got to do the work, and then you

got to wait another 120 days. So you paid payroll for, I don't know how long, in

order to get your money and so a lot of times you want to balance that with other

customers that pay you right when you do the work and so people shrink,

sometimes they turn business away because they don't want to wait 120 days to get

their money. We dealt with it with a client not too long ago that literally if you

don't agree to 30 -day terms, he just won't do your work. I'd like to be in that

position, right? Because everybody wants to be in that kind of powerful position and

because they don't need the work, but most of the time you go in after collecting

money as quickly as possible. You've heard, Michael, I guarantee you've heard in the

retail world of sort of this just -in -time inventory concept where you you're not

buying the inventory until you absolutely have to have it that day, right? And so

your inventory is as low as possible. And so people outsource their fulfillment,

you know, in order to decrease their inventory to their suppliers,

basically. And so we talked about that furniture manufacturer that I used to have as

a client who didn't, who had the foam manufacturer actually manufacture the finished

product rather than buying a whole bunch of foam and having to rework the foam

internally and have this huge inventory. A lot of people stretch vendors,

right? So, if I'm only going to get my money in 120 days and I don't want to pay

my vendors before then either, you know, I want to try and stretch my vendors and

and so Some people can't do that And so they borrow a line of credit from the

bank in order to give them the working capital to pay that Those expenses while

they wait for their money. Those are the kinds of the simple ways that people do

to to try in and and make sure that they improve their working capital.

- I know a big thing is also where it's all,

I know we've kind of talked about how, and this has to do with kind of your

machining companies, manufacturing companies, they'll invest in work

that does require less payroll, right? And so for example,

like buying robotics, right? And so it does take less payroll. And so that's going

to increase it just because, I mean, look, you can stretch out your vendors, you

can't really stretch out your payroll, right? I mean, that you can't do that. And

so you if I've seen people invest in the in the in robotics and things like that,

the non heavy payroll work and some people just can't do that.

But that is something that I've seen some people do for sure. Yeah, that's

absolutely correct. I think the other thing is this is why you see,

like in the body shop business for example, there's a push to finish jobs jobs on

Friday. You know, it's not just because insurance companies don't want you to keep

the rental car over the weekend. That is a big deal. But it's also, I want to

finish the job on Friday so I get paid on the same day as my payroll goes out

the door. Does that make sense? And so, and so you, you know,

you also get these manufacturing companies and fabricators that want to, that know

that the clients are going to pay a March 31st invoice before the end of April.

So they're pushing to finish the job by March 31st because if they wait until April

10th to finish the job, they may not get paid until the end of May Because those

huge huge companies that are buying that those products a lot of times they want to

pay bills once or twice a month

So there's there's there's every company is different And and every you know,

I mean, that's why You know as a small business owner, I remember the pain of

Having to do the cash flow dance, you know, we've got to meet payroll every week,

you've got supplies, you've got a counter -seable, you're kind of managing that on a

daily basis and it's hard. And so as you get more successful,

your business owners will sort of accumulate cash and leave it in the company so

that they don't have to bother, they just pay all the bills every couple of weeks,

right? And so that you're not getting calls from vendors, you're not, and you really

have excess working capital in the company in order to not have the headache of

having to manage it every single day, right? So I don't have to hard collect on

clients or get old panic 'cause I've got to meet payroll on Friday if I've got a

whole bunch of money in the bank. And that's what we call excess working capital.

It's more than you actually need. Does that make sense? - Yeah, I think another one

is that, I mean, we had a client that would, he was kind of in landscaping,

right? And he would bill very inconsistently, right?

And he would collect it very inconsistently. And so, But, and I say inconsistently,

it was just a, he just wouldn't bill for a long period of time, right? And so

when we looked at the financials, it was always this revenue that was just like one

month that was a ton and then one month, one month that just wasn't very much at

all. And, and it was just this up and down thing. And, and, and kind of when we

were first talking with him, he told us that, yeah, no, we don't, we don't, uh,

bill on a consistent basis. We don't collect on a consistent basis. And look, he's

done well to where he always has enough work capital to sustain his business,

to do payroll, to pay his bills, all of that. But at the end of the day, to

build that work capital, it's okay. You can plan. You can be more consistent and

Especially with hard collecting, you don't want to get into a position where you are

really trying to hard collect your clients,

because that can hurt relationships too, right? And so, especially when they're

recurring, and so that's something that I know is going to be important just by,

hey, having a process of that is something that you can do to increase or I guess,

yeah, if you're saying increase or capital has really just been consistent.

- Improved, yeah. - Yeah, improved, there you go. - I think, and this is,

we've had a lot of clients that go from being what we call a small business to

sort of a medium -sized business, but they still manage out of the checkbook.

If there's a big cash balance, then they're doing great, and they will make a

distribution without really anticipating what their working capital situation is. This

goes back to the whole comment that I made earlier, and that is, it's a great

management tool. You've got to, as a business owner, you've got to anticipate what's

coming down the pike in a couple of months, because you got $5 million in the bank

and you go, "You know what? I could take a million dollars off the table and

invest it personally or invest it in something that I want to do outside of the

business."

And I might cause a headache for myself in the next couple of months because I'm

not able to build those clients or I need to purchase some robotics or whatever it

is, you may shoot yourself in the foot. And so thinking ahead of what I'm going to

need is a big part of what working capital is. I had a client years ago who was

super unsophisticated, he was super smart and he took this calculation of working

capital and he created what he called the magic number. And every morning on his

desk, it was a, at that point, it was a pretty large company, nationwide stores and

manufacturing. And he, on his desk, every single morning was this magic number,

and obviously the parts of it. He managed the trends of working capital and that's

how he knew what was going to happen cash flow wise in the next couple of months.

So much so that if he saw negative trends, he then went to his marketing division

and said, "Hey, I need to get rid of some product and so I need to do super

duper deals. He was actually from Columbia and he used to call them super duper

deals and so he used to discount the product in certain areas of the country in

order to raise cash that he knew he's going to need in the next couple of months

for working capital And so it's a great tool. The calculation is a great tool,

but you have to have the accounting systems that are halfway decent in order to

monitor, certainly on a daily basis. Most people don't, but at least on a weekly

basis. In the businesses that we've run in the past, I've always had that

calculation and other metrics, by the way on a weekly basis.

When we were in the body shop business, I wanted to know how many cars were

dropped that week, how many cars were delivered that week. I want to know how many

gift cards, not gift cards, how many thank you notes were written.

And so as an owner of a business, business, what you measure gets done.

And so when you, you know, the reason I didn't care to have the number of thank

you notes, but I knew that for them to have to put down a number, they were

thinking, "Oh, I need to write thank you notes." And so what you measure gets done,

and if somebody's having to report to you what a count receivable is that week,

is not just a value of having that number and being able to plan with it, it's

also telling your employees, "Hey, I'm keeping an eye on what that balance is,

and if it all of a sudden goes extraordinarily high or the aging gets messed up,

I know that I'm going to have a cash flow crunch in the next few weeks." Hey,

Grant, earlier, you talked about the importance of consistency when calculating working

capital. But you also kind of hinted at the fact that there's different ways,

there's some variations in the ways to calculate it. So when helping our clients

through working capital conversations, how does ICCG calculate working capital that

might be unique? Yeah, you know, in our different businesses over the years,

it all depends on the business, and I'll give you an example that's not one of our

businesses, but one of the ones that we've sold in the last few years. When we

sold a fence company, they didn't necessarily include all of the posts and sales,

and things that were work in process in the normal inventory number.

And typically, that's part of inventory. It's what some other companies call work in

process. You know, a lot of our manufacturing companies, their fabrication, you know,

they're in the middle of a job, but the job only takes a couple of days. So,

they don't count it as inventory, and so it's not right, but if you consistently

don't count that, then you can measure the trends appropriately.

But if all of a sudden, one week you calculate it and one week you don't, it's

just not going to give you the right data. And so, in some companies,

They don't even calculate, they don't even put, you know, any kind of accrued

payroll in there because they only do it once a week or like on Fridays and

they've just paid payroll.

And in some instances, they don't include it, but they pay payroll once every,

or twice a month and, you know, some of the and salesman,

they only get, they commission the following month, but they don't accrue that

payroll. As long as you just consistently don't do something or you consistently do

do something, it just helps you measure trends properly rather than all of a sudden

the numbers different and you go, "Oh my goodness, what happened?" And really nothing

happened, you just change the way you calculated the number. So, Grant, you talked a

little bit about the magic number, right? And having that is kind of the key to

help you run your business and that you can get in front of that when you kind of

know what working capital does for your business. What can happen when you don't do

that? What can happen when you don't use working capital well, you don't know what

your business needs to run, and you get to

looking a business. Yeah, it's, you know, a lot of times, and this is just, you

know, I probably need to apologize on the back end to all my banking friends.

But when you need working capital, they're not willing to lend it to you for the

most part. And so, and so just, you know,

it becomes too late and you're having to scrap to generate cash in order to cover

up the lack of working capital and so if you can't borrow it you've got to fire

sale products you've got to give deep discounts which you know what that does in

the short term it helps you because you get cash but in the long term it really

makes you suck and so you know I mean at the end of the day you know you You

want consistency, you want to make sure that you know ahead of time so that you

could have time to mitigate the lower cash flow that you might get based on your

current performance. And so any kind of dashboard or indicator,

and everybody has them, every business owner I've ever had, they all know, oh,

okay, that's happening. So that means that next month I'm gonna hurt or next month

it's gonna be great. You know, I think those are the important indicators and I

would just tell you if a business owner is not monitoring working capital, are

cheating themselves because they're losing out on a great indicator of the trends in

their business.

That's great.

Well that's almost it for today's conversation. Before we kind of transition that

next conversation about what it actually looks like in a deal, how it plays out,

talk about how a company's working capital position, can play into the decision to

pursue a sale? Yeah, I think here recently, you know, we've talked to a company

that has, you know, that they believe that company is worth a certain amount.

And I agree. I think that company is worth that amount. The problem is,

is that they've taken on a lot of customer deposits or prepaid revenue and so in

order for a buyer to pay, I'm just going to use a round number,

$100 for that business, then they're going to have to have,

you know, those customer deposits to generate the next revenue, the next month's

revenue, right? And so it's super important to know what your working capital is and

what the nuances are, what the needs are, so that you know what you're going to

get from the sales price. And so it might be that you're one of those guys that I

described earlier that has a lot of excess working capital because you just don't

want to have to manage cash flow. And so you leave millions of dollars in the bank

that you don't really need in the bank, but it's just sort of a safety blanket

that kind of covers up the need to manage. And so you might get more than the

purchase price because if there's excess working capital, then you should get paid

for that excess. And we'll get into that in another episode. But I think the most

important thing is to know, okay, I'm not going to have to come out of pocket.

It's kind of like getting, you know, your $10 million for your business. And then

after the fact going, wait a second, I was structured as a C Corp. So I'm only

going to end up with six million dollars and you only hear that after the fact.

You would be shooting your advisors if that was the case. The idea that you

wouldn't know that you'd have to leave half a million dollars in the bank account

when you sold your company would be disastrous because you were anticipating taking

that home. You see what I'm saying? And so it's super important.

You know, we talk about the value that advisors bring to the table. I personally

think that the value is not in the decision making 'cause our clients are smart.

I mean, they haven't built successful businesses because they're idiots. They are very

good at making decisions. What they don't have is understanding of a transaction and

they don't want surprises. And so if you just lay out the facts in front of them,

they make great decisions, but they need to know the facts. And when they get a

surprise, how do I deal with it? And then they go, I wouldn't, I wouldn't just

sold my If I knew I was going to have to come out of pocket, you know, $4

million, you know. And so we just, we just like to minimize the surprises,

let them know how working capital is going to, going to impact their transaction

possibly, and, and then manage the, the negotiation so that it lands exactly where

the seller wants. That's great. Well, that's all the time we have for today,

Andrew and Grant, thanks for joining me. Please make sure that you guys join us for

our next episode where we will be talking about working capital during a business

transaction.

And that wraps up another episode of Integrated Insights with ICCG. Be sure to

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