Managing Cash Flow and Working Capital

Managing cash flow and working capital

How to reap the rewards of good inventory management

http://www.jpabusiness.com.au/

jpabusiness.com.au +61 2 6360 0360 2

Table of Contents

Introduction ........................................................................................................... 3 Cash flow .................................................................................................................................................................. 4 Working capital ..................................................................................................................................................... 4

Chapter 1: Don’t pay the price of poor inventory management .............................. 5 Costly legacies ........................................................................................................................................................ 6 Beauty (of stock) in the eye of the beholder ................................................................................................. 6 Too little stock also costly .................................................................................................................................... 7 A timely reminder ................................................................................................................................................... 8 How stock holdings are valued .......................................................................................................................... 8 How to ensure your stock holding maintains its value ................................................................................. 9 Don’t be tempted to sell off excess stock quickly ......................................................................................... 9

Chapter 2: Managing inventory to maximise value ................................................ 10 How much stock is too much? .......................................................................................................................... 10 How to calculate Inventory Turnover Ratio ................................................................................................. 11 Hold excess stock at your peril ....................................................................................................................... 12 Why doesn’t inventory management get the attention it deserves? .................................................... 13 Assessing your working capital position ....................................................................................................... 13

Chapter 3: JPAbusiness Working Capital Checklist ................................................. 15 Working capital checklist ................................................................................................................................. 16

Chapter 4: How cash flow and working capital impact business value ................... 20 What we look for in the due diligence process ......................................................................................... 20

Disclaimer: The information contained in this eBook is general in nature and should not be taken as personal, professional advice. Readers should make their own inquiries and

obtain independent advice before making any decisions or taking any action.




Introduction

Comments by James Price JPAbusiness Pty Ltd

When we started our eBook series, about two years ago, one of our first eBooks focused on cash flow.

Cash Flow Management for Small to Medium-Sized

Businesses was written post the GFC, because we saw cash flow management as an important success factor for our clients in managing the dynamics of their businesses in a challenging environment.

We recently completed the transaction on a business sale for a client and it served as a reminder of how important both cash flow and working capital are to the success of a business.

In particular, it reminded us how important they are to building business value and therefore, when exiting a business, receiving value from the marketplace.

The levers that impact cash flow and working capital are critical to running a successful business day to day, but they are also critical to building business value over time.

This eBook will address those levers, paying particular attention to the inventory ‘lever’. A lot of money can be made or lost based on your inventory management, as our recent experience proved.

First up though, a couple of definitions…



http://www.jpabusiness.com.au/e-book/cash-flow-management-for-small--to-medium-sized-businesses-e-book




Cash flow Cash flow refers to the amount of surplus or deficit cash a business generates within a specified period of time.

Cash flow is almost never equal to net profit as companies tend to sell on credit and borrow money.

Furthermore, the cash generated through sales can be reinvested in the business or other assets, such as real estate, shares and interest-bearing investments.

Therefore, your accountant or advisor cannot simply compare the cash at hand at the beginning and end of the accounting period to determine cash flow.

Instead, they prepare a special report, called the Statement of Cash Flows.

Working capital Working capital is the difference between a business’ current assets (e.g. debtors, inventory, etc.) and current liabilities (e.g. creditors, short-term lines of credit, ATO and employment liabilities).

In accounting and finance, the term ‘current’ refers to assets that can be turned into cash, or liabilities that are due in less than 12 months.

Because both figures are stated in the balance sheet of a company or firm, the calculation of working capital is a simple task.

A large amount of working capital means the current assets of the company are more than sufficient to cover current liabilities that are soon due.

Negative working capital means the company may not be able to pay upcoming bills with the amount of money, soon-to-be-collectable receivables and other assets, it holds that can be turned into cash on short notice.




Chapter 1: Don’t pay the price of poor inventory management Comments by James Price JPAbusiness Pty Ltd

Recently we were involved in facilitating the sale of a strong, independent business involved in import and distribution.

It was a well-known, independent brand that had been established for well over 50 years. It had a lot of history and solid bottom-line performance.

Overall the business was successful in delivering what it promised to its customers and had been successful in delivering value to its owner day to day.

Unfortunately, when it came time to exit the business and realise its value in the marketplace, there were a few legacy issues that provided some difficult negotiation challenges.




Costly legacies Sometimes, many years in business delivers great benefits – and it had for this business – but it also leaves some less positive legacies.

One of the legacies that was very clear in selling this business was the amount of inventory (stock on hand) – it was very significant.

We negotiated a price for the goodwill, plant and equipment etc, based on a multiple of Business Maintainable Earnings (BME), which is essentially the cash flow of the business.

Then it was time to address the stock value.

Usually stock on hand is valued by way of a stocktake and its value is paid by the purchaser at completion.

Ideally, its agreed value is the buy price the vendor paid for the stock at the time of the original purchase.

In this case, and unfortunately this is something we are seeing quite often in business sale transactions, there was considerable disagreement about the value of the stock on hand – a difference of 50%.

The buyer basically said: “You have X amount of stock, but a reasonable level of stock to run this business is Y. I don’t need X amount so I won’t pay for it. I will pay for Y.”

Beauty (of stock) in the eye of the beholder Often people who are not adept at managing inventory will have excess stock because it feels good to know they have it in case someone wants to buy it.

However, they don’t necessarily think about the value of it.

In the meantime the stock may be diminishing in value but, as purchasers often joke, the vendor thinks they have ‘gold’ sitting on the shelf or in the warehouse.




As a vendor you may say: “I’ve been in this business for many years. If you don’t have the stock you can’t sell it. Therefore I would rather have this stock holding than run short.”

That’s fine. You’ve been in the business for years and understand the cycles, but the purchaser is just looking at the figures on paper and it seems too much. Chances are they’ll go with their calculation, and often times this is also being supported by their advisor.

Beauty is in the eye of the beholder when it comes to stock value and sometimes that is a very difficult concept to accept during a sale process.

Too little stock also costly There is, of course, a balancing view point, which is important to consider.

A business that is low on stock is often one that doesn’t maximise its product sale opportunities.

Therefore a purchaser should always listen closely to an owner when they talk about stock turn and inventory levels – these are not black and white issues and every business owner will have a different approach to their inventory level. These approaches mirror an owner’s risk appetite and way of doing business.

There is no right or wrong, but there are significant consequences for decisions about inventory levels.




A timely reminder The disagreement between vendor and purchaser outlined above represented a large reduction in the value of the business to the vendor – several hundred thousand dollars.

It also meant the cash flow the owner had diverted to stock holdings over the years was lost – he couldn’t get that value back out.

This experience was a timely reminder to me that business owners who do not actively manage their inventory holdings will find it comes home to roost when they sell.

If only that inventory had been more closely managed, the business owner, on exiting the business, would have actually got the value of that inventory back. They would have realised it either in the purchase price for the stock sold, or in getting the cash flow back out of the inventory when they were managing it day to day.

It heightened my awareness and made me keen to warn other business owners: “Don’t forget inventory, because there’s big dollars to be won or lost there as a business owner.”

How stock holdings are valued A purchaser will value your stock holding based on a calculation of your sales over a particular period.

They may look at the dollar value of sales you have made in the past six months or 12 months, then reference that dollar figure against the level of stock.

For example, you have made $250,000 worth of sales of item A in the past 12 months. However the value of stock on hand of item A is $350,000.




In your industry, a stock holding that represents 12 months’ worth of sales might be the maximum you need.

In that case, why would they pay for $350,000 worth of stock when they only need and want $250,000 worth for their first 12 months of trading?

How to ensure your stock holding maintains its value Inventory can provide positive cash flow, but only if it is managed like a share portfolio.

For example, most people who have shares will actively look at what those shares are worth on a daily, weekly or monthly basis to see how they are trading versus the market.

If the shares are underperforming, they will be sold.

Similarly, inventory must be closely managed and moved on when necessary.

Don’t be tempted to sell off excess stock quickly Simply planning to reduce your stock level just before selling your business, however, is not a good option.

This will reduce the margin on the items sold and create a sudden reduction in your gross profit, which will negatively impact the Business Maintainable Earnings (BME).

As we've discussed in other eBooks, BME is a key consideration when assessing business value.

Rather than losing money on the stock, you will lose money from the business price.

If you have over-stock or obsolete stock items, they must be sold off gradually, over an appropriate period of time.



http://www.jpabusiness.com.au/blog/posts/james-price/2013/09/08/how-to-calculate-sustainable-earnings



Chapter 2: Managing inventory to maximise value Comments by James Price JPAbusiness Pty Ltd

How much stock is too much? As a rule of thumb, a stock holding that represents 12 months worth of sales is the maximum needed.

However, it’s very hard to generalise.

Some businesses are import oriented so need to commit to a certain level of stock to ensure their freight rate is not exorbitant and/or they have sufficient stock ordered from a single season pre-order. This may cause lumps in their stock holdings.

At the other end of the scale there are some products that are rapidly changing in terms of the market acceptance due to changes in technology.

For example, in the retail telecommunications sector, mobile devices, accessories and related products all change technology rapidly and brands are constantly bringing out new versions.

A 12-month stock holding of sales in that sector would be far too extensive. In such an industry, four to six weeks might be considered more appropriate.




So 12 months of stock holding is a barometer, but it can’t be a rule. Instead, use it to trigger further investigation.

In all cases, purchasing in bulk to improve margins should not be considered in isolation. The relative ease of transport within the global economy and the speed of obsolescence must also be weighed up.

How to calculate Inventory Turnover Ratio One of the simple ways of testing your position on inventory is to use the Inventory Turnover Ratio i.e. stock turn. Stock turn is the number of times in a year that stock turns, or is sold.

ITR = Annual Cost of Goods Sold/Closing Inventory Value

For example, your annual cost of goods sold is $1.25 million and your inventory level at the end of the year is $400,000.

Your stock turn is $1.25 million divided by $400,000, which is 2.8 times.

You can then divide the number of days in a year by your ITR (i.e. 365 days divided by 2.8) which gives you the days of inventory on hand (in this case 130 days). This is the number of days you have before you run out of that item.

ITR benchmarks will vary depending on what industry you’re in. They will be impacted by things like:

• how quickly stock usually moves; • how long the sales process is, and • how long the order process is (to the extent you can just-in-time order

to fill a customer enquiry, versus having stock ready for them when they need it).

We can’t give you a hard and fast ITR benchmark in this eBook, but it is a simple ratio to give you a feel for how your inventory is going and to pressure test whether you’re managing your inventory closely.

You might like to seek more information or assistance from a business advisor or your accountant as decision support for your inventory management processes.



http://www.jpabusiness.com.au/advisors-to-business


Hold excess stock at your peril You may be one of these business owners who takes comfort in thinking “my inventory of an individual item is three times my annual sales, but that’s great because you never know, someone might come and want it”.

That’s fine, it’s your decision, but just remember you’ve got cash flow and working capital tied up in that inventory and that will be impacting your cash flow.

Also keep in mind that you may think your stock is worth 100% of what it cost you, but chances are that if you go to sell the business, the buyer won’t give you 100 cents in the dollar for it.

In fact, it can be quite penalising in terms of what you get back.

Just like in a share portfolio, if you have an underperforming share and you choose to leave it on the shelf and not do anything about it, eventually you will get a few of cents per share instead of the dollar you paid for it.

Critical to managing your working capital, and therefore business cash flow, is to manage your inventory closely, not just for today but for the future, in terms of the value of your business.




Why doesn’t inventory management get the attention it deserves? There is a lot of money to be won and lost in inventory management, but there are a range of businesses, some of them quite large albeit still in the SME range, that don’t have inventory well recorded in their financial and business systems.

This may be because to manage inventory well you’ve got to go down to quite a level of detail around items, sales and stock holdings, and really think about: ‘have I got enough, have I got too much, what’s my order cycle, what’s my sales cycle?’

Eventually it becomes second nature because you get a gut feel about whether you have enough stock or not, but there is quite a bit of analysis involved.

Assessing your working capital position In the past two chapters we’ve looked closely at inventory, because it is an important and often overlooked component of working capital, and therefore cash flow.

In the introduction we defined working capital as the difference between current liabilities and current assets.

To understand your working capital position you can use the Working Capital Ratio (WCR), which is known as the Current Ratio.

Current Ratio = Current Assets/Current Liabilities

The goal is for assets to be more than liabilities (i.e. a Current Ratio of 1.0 or greater) and the more positive that number, the better in terms of the working capital position of the business.

Of course, ratios are only as accurate as the figures you use to calculate them.




For example, is your inventory really worth X dollars, or is there obsolete stock, old stock, or simply stock that is surplus to actual sales levels, that mean the inventory is worth less than actual face value?

If you’re not completely honest about what your inventory is worth, you could be fooling yourself about your working capital position.

In the next chapter we'll examine some more ways to manage your working capital.




Chapter 3: JPAbusiness Working Capital Checklist Comments by James Price JPAbusiness Pty Ltd

As business valuers and brokers, and in advising clients on business performance and aspects relating to financing their businesses, there is a critical thing we look for: liquidity.

Liquidity is effectively how much cash a business generates and how stable and frequent that generation is.

We’ve talked in the past about business maintainable earnings (BME or ‘sustainable earnings’) which is essentially a measure of cash generation in the business.

That ability to generate cash is a critical component when it comes to determining the value of a business.

A bank will look at BME because it wants to know how much cash is in this business to service the business’ lending and other commitments.

But a purchaser will also look at BME because they often have to borrow money to buy the business, so they want to know how much cash is surplus in the business to meet their likely commitments.

And also, as we’ve often said, owners need to think about the value they get today in running the business, versus the value they get in the future when they sell.

So the more cash surplus, the more liquidity in the business, the more value they’re deriving from the business in their pocket today.

But cash surplus – working capital – also gives a business more options to grow, invest and change, because it’s not constrained by that four-letter word: cash!






Working capital checklist As a business owner or manager, there are a number of levers you need to control to successfully manage working capital and drive a successful, cash-generating business.

We’ve created the JPAbusiness Working Capital Checklist to help you manage those levers. Use the checklist included here, or download a pdf version from our website.

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JPAbusiness"Working"Capital"Checklist"s a business owner or manager, there are a number of levers you need to control to successfully manage working capital and drive a successful, cash-generating business.

Those levers fall into two buckets: current assets and current liabilities.

Use this checklist to assist you in achieving a firm control of your working capital levers and cash position, so your business proposition is not hampered by poor cash flow.

A

Working(

capital(leverDefinition Management(checklist

CURRENT(ASSETS"

1. Cash

and cash

equivalents

Cash in the

working

account

! If you choose to fund working capital with surplus cash, ensure you have easy access to surplus funds to meet commitments.

! Have a buffer over your estimated commitments, if possible.

2. Short-term

investments

Investments

with a maturity

date of less

than 12

months.

! Consider using a short-term investment strategy if there are major peaks and troughs in the cash generated in your business. This may be due to rapid growth, project mobilisation or other market factors.



http://www.jpabusiness.com.au/e-book/jpabusiness-working-capital-checklist



Working(

capital(lever Definition Management(checklist

3. Accounts

receivable

Debtors ! Ask the hard questions of a new customer regarding payment history. Consider tightening payment terms until they’ve established a positive track record. Use credit rating agencies.

! Set standard timing for invoicing and stick to it. Document and agree on your payment terms (‘terms of trade’).

! If you send out invoices with 14-day payment terms, then on day 13 make sure there is a calling program. Call all your key customers due for payment the next day and speak to the decision maker or accounts person responsible.

! Monitor payment and resolve disputes quickly.

! Unless you’re a bank, don’t act like one. Some businesses have payment terms that state ‘the payment period is X days – if the account is not paid in X days the customer will be charged interest at a daily rate of Y per cent’. Interest being charged doesn’t necessarily help your cash flow!

4. Inventory Stock on hand ! Record your inventory.

! Record, item by item, what monthly and annual sales are versus your inventory holding.

! Ensure your inventory holding matches your sales and supply cycle.

! Review your inventory at least once a month to appreciate whether it’s over- or under-valued versus your business needs.

! Be aggressive about writing down inventory and/or divesting or removing obsolete items.

5. Prepaid

expenses

Services

purchased

upfront

! Be selective about which services are pre-paid. You may receive a margin or cost benefit through such a strategy, but remember you are potentially tying up working capital.





Working(


CURRENT(LIABILITIES

6. Accounts

payable

Creditors ! Meet your commitments when they’re due.

! If you wish to pay accounts early, ensure you receive a better margin for doing so.

! If you have a track record and a relationship with suppliers, look for opportunities to extend your payment terms. Document and agree a fair arrangement upfront.

! Spot opportunities to remove or minimise timing gaps between debtor and creditor payments.

! Talk ahead of time to creditors if you have cash flow problems.

7. Short-term

debt

Line of credit

or overdraft

! If you choose to fund working capital with a line of credit (debt funding), ensure you have easy access to surplus funds to meet commitments as and when they fall due, in case limits are pressured.

! Have a buffer in your line of credit over your estimated commitments, if possible.

! Try and achieve a credit position once a month with your overdraft. If this is not frequently achieved it may mean you have core debt in your overdraft rather than simply working capital. If so, talk to your financier about loan restructure options.

8. Current

commitments

Commitments

within next 12

months e.g.

interest on

five-year loan

! Budget for major loan interest and repayment obligations, as these can cause ‘lumpy’ impacts on cash flow.

! Plan ahead for residual payouts on plant and equipment leases – another potential heavy impact on cash flow.





If you would like to learn more about the business advisory and broking services

offered by JPAbusiness, please contact the team by visiting www.jpabusiness.com.au/contact-jpabusiness

Please"feel"free"to"post"this"template"on"your"blog,"or"email,"tweet"and"share"it"with"your"network.""

Working(


9. Salaries Include

accompanying

payments e.g.

superannuation

! Employees are a critical part of your business – ensure you always have cash flow to meet wage and salary commitments.

! Budget and provision ahead for other statutory obligations to employees, such as superannuation payments and accrued entitlements for annual leave and long-service leave.

10. Taxes and

regulatory and

statutory

payments

GST, income

tax, etc.

! Actively manage and monitor your tax, regulatory and statutory payment obligations. Have your team estimate these ahead of time when cash flow is tight to ensure you are able to meet commitments.

! If you suspect you’re going to be seriously challenged in meeting these commitments and can’t see any alternatives, talk to your accountant or advisor about contacting the ATO about a possible payment plan.

! If you get behind and overdue, you are too late. Missing payments to the tax office will negatively impact your standing with both the ATO and your bank.




Chapter 4: How cash flow and working capital impact business value Comments by James Price JPAbusiness Pty Ltd

Working capital, cash flow, inventory, debtors, creditors – these are all day-to-day business levers you need to think about as a business owner.

Sometimes, we’re so caught up in the wash of business, trying to run the thing, we take these levers for granted.

We also take for granted the fact that while these levers contribute to the daily value of our business, they’re also critical to our succession and exit plans – to our ultimate business value.

What we look for in the due diligence process At JPAbusiness we often undertake commercial and financial due diligence for purchasers looking to buy businesses.

Cash flow and working capital, accounts receivable and payable, and inventory are some of the key things we examine in a due diligence process:

Surplus cash – How much surplus cash does the business generate and is that cash generation sustainable?

Often that simple calculation will feed into our view of Business Maintainable Earnings (BME) and therefore significantly impact our perception when advising the purchaser of what the business is worth.



http://www.jpabusiness.com.au/e-book/buying-a-small-to-medium-sized-business


The debtor’s ledger – Also known as accounts receivable, these are the people who owe you money.

We look at the strength of that ledger and the ability over time for your customers to pay what they owe to you, on time.

Accounts receivable is one of those assets you might assume can be taken at face value, but what if your debtors aren’t meeting your terms?

Effectively, the debtor’s ledger is a portfolio and if it is out of order by large, significant amounts, you will be penalised.

This is because the purchaser is taking on that portfolio of customers and their poor performance in terms of payment.

For instance, if your payment terms with customers are 30 days and your debtor’s ledger shows that 30% of the value of your debtors are overdue by 90 days or more, that will impact your working capital and cash flow.

The risk that a purchaser will perceive is that they won’t get 30% of debtors on a monthly basis, based on what’s occurred to date. We will respond by marking down the value of your debtor’s ledger, from a due diligence perspective.

That’s why a day-to-day lever in this area is so critical to you, the owner.




Inventory – We’ve talked about the face value of inventory versus the real value and how vendors tend to think they have ‘gold’ on the shelves.

Don’t fool yourself by thinking you’ve got X dollars of inventory when the reality is, to run your business successfully, you only need Y dollars.

Be honest and upfront with yourself regarding what the real value of your inventory is.

Put yourself in a purchaser’s position and think: “If I was to buy my business today, how much inventory would I really be prepared to pay for and at what dollar value?”

If you’re not sure, get some advice around what a reasonable inventory holding is, how to ensure you get the most value out of your inventory and how to dynamically manage it.

All these components are closely watched in a due diligence process by a purchaser and their advisor looking to buy a business.

We know because we run those processes for clients and those components go heavily to making up the value exchange in a business transaction. They’re all levers that can be heavily influenced by a business owner.

Yes, they are impacted by market forces, things that happen to suppliers and customers, but largely they can be influenced by you. Ignore them at your peril.

Address them, utilise them, and you will be rewarded with a business that generates cash day to day, and builds value over time.

If you would like to learn more about the business broking and advisory services offered by JPAbusiness, you can contact the team by visiting www.jpabusiness.com.au/contact-jpabusiness



http://www.jpabusiness.com.au/contact-jpabusiness

Managing Cash Flow and Working Capital

Business

Transcript of Managing Cash Flow and Working Capital