Why you need to take a long-term view when managing your working capital
Companies that lack purpose in how they manage working capital can easily find themselves responding to one funding problem after another, says Justin Vogel, vice president and business line manager for Capital Finance at Bridge Bank.
“When you don’t have a plan, you manage your working capital on a reactive basis and don’t recognize until the last minute that you’re going to run short on cash,” Vogel says. “You have to find a quick solution to get cash rather than relying on a plan that is more cost-effective and ensures that you’re operating with liquidity at all times.”
Working capital is the lifeblood of your business. When it’s not managed proactively, it can severely limit your ability to grow your company.
Smart Business spoke with Vogel about best practices when it comes to managing your working capital.
What is a common mistake companies make in managing their money?
Some companies will routinely offer discount terms to their customers in an attempt to get paid more quickly.
However, if you annualize those discounts over a 12-month period, you’ll likely find that you end up paying out significantly more money in discounts to customers in your effort to get that cash more quickly. Often, the more affordable option is to get a bank line of credit and pay interest on that.
Typical discount terms are 2 percent if the customer pays within 10 days. If that customer is buying from you every other month, that adds up to 12 percent a year. The discount option may seem like a win-win for both you and your customers, but it usually does you more harm than good.
What can companies do when they don’t have a full-time CFO?
It can be a tough spot to be in when your business is growing, but hasn’t reached the point where you can afford to hire a full-time CFO. Many companies in this situation are not big enough that they need full-time service. One option to consider is hiring a part-time CFO.
Some companies rely on a bookkeeper or CPA, but the way the rules are written, CPAs need to be careful with the type of consultation they provide. A part-time CFO or consultant can check in with you on a regular basis and help you to make better and more informed decisions managing your working capital.
How much can a bank line of credit help a business?
A line of credit can help your business get cash before you get paid by your customers.
Some banks have two different lending tiers: A corporate group that handles more traditional banking needs and a capital finance group that focuses on asset-based lending. From a term, structure and pricing perspective, there is a significant gap between these two options.
The capital finance group is typically going to be more expensive and more structured from a collateral standpoint while the corporate finance group is going to be less in these areas, but more restrictive from a covenant perspective.
How can tax concerns restrict your profitability?
A company may decide to distribute profits to the ownership or management team in an effort to minimize taxes at the corporate level since they tend to be very expensive. But this step can have a negative effect on a company’s equity.
When profits are moved out of the business, they would otherwise flow through to the equity position of the company and onto the balance sheet. Over time, this can put a company that takes this action in the position of being overleveraged.
Most traditional bank financing options will require a debt to net worth ratio of 3-to-1. If the equity isn’t there, the debt component of that ratio can’t be very high at all before you start getting over that number. So you need to ask yourself: Is the tax savings worth the higher interest expense that you’ll have to pay on second tier debt options if you’re not building up that equity component on your balance sheet?
As you manage your working capital, you need to think about the long-term impact and cost-effectiveness of your decisions. The upfront investment you make to develop a comprehensive plan will be well worth it.
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