Net Working Capital - The Missing Piece in Your Business Growth Plan?

Net working capital is crucial to any business. It’s the metaphorical grease that keeps the machinery of your enterprise churning out sales and profits. Yet it is often overlooked and/or its need underestimated, especially in growing businesses.

People often joke about how “you have to spend money to make money”. This is most definitely true. That said, the focus of this phrase is often on the capital investments in land, property, plant, and equipment necessary to bring a project from concept to reality. While it’s true that every business requires capital expenditures, the attention afforded to big ticket items like machinery and equipment, can result in losing sight of working capital which is necessary to assure the machinery can be run.

So what is net working capital?

Defining Net Working Capital

In accounting lingo, net working capital by its simplest definition is the difference between a firm’s current assets and current liabilities (categorizations found on the business’s balance sheet). In normal peoples’ speech, it’s a measure of the short term ability of a business to generate sufficient incoming cash to make good on its promises to others.

Typically, the larger the business, the more net working capital needed to operate effectively. To take a simple example, if my business has one active project, it needs a certain amount of working capital to fund the business while we wait for payment from the customer. If I add a second active project, the need for working capital increases, as my obligations to employees, vendors, and others will likely expand. This expansion could be very profitable for my business, but in the short run it may put a strain on my cash position.

The Misunderstanding About Net Working Capital

When a business owner is considering a new opportunity, it is very easy to focus on margins. Perhaps a new piece of business offers a 30% net margin, which may be very attractive in a certain industry. While margins are a critical consideration for any new business opportunity, it’s also important to work on the net working capital needed to successfully deliver the new business. Depending upon the industry there could be days, weeks, months, or years of working capital needed to deliver successfully.

To get this right, it’s important to consider all the factors of production, lay them out in time sequence, and determine the implications for working capital. With this type of analysis you can understand if a project can be self funded or may require outside capital to successfully fulfill.

Does your Company need assistance with its growth plans? Reach out to Doescher Group for help.

Who Spends the Money?

What seems like a simple question isn’t so simple, is it? If you’re a business owner, you know what I mean. As soon as you introduced a second individual into your business, this became an issue. Today, depending on your organization’s size this could be a huge issue.

I’ve seen organizations with no expense control, which result in constant unexpected spending surprises. On the other hand, I’ve seen organizations where the owner authorizes every single purchase, which can suffocate the business. Finding a happy medium comes through process and accountability.

For purposes of this discussion, we will focus on the importance of building a process that works for your business.

Process

The old adage goes: “If you fail to plan, you’re planning to fail.” In the case of spending, this is definitely true. In a prior post titled, “The Dreaded Budget”, I discussed the importance of the budgetary process as a tool. Extending this to expense control, it is critical that a process is in place to connect budgetary goals to actual spending activity.

What this means practically, is that individuals involved in spending money must be informed of their budgets and be provided authority to control their spending. This can be handled by department, accounting codes, or any number of ways. It can be done through a purchase requisition and purchase order system, or something else. It just needs to be done.

If the individuals spending the money don’t know what the budget is and have no mechanism for managing to their budget, 9 times out of 10 they’ll overspend.

Accountability

Setting up a process is just the first step. As many of you know, some businesses are littered with well-intended, failed processes that have been cast aside. Some companies churn through processes at record speed jumping from fad to fad (so-called “flavors of the month”). Everyone follows the new process for a little while and then everyone moves on. The necessary changes don’t take hold. In other organizations, the processes are adhered to, but merely as a formality. One example of this would be a purchase requisition process, where the approving party automatically approves every request, completely missing the point of the approval gate.

So how do you avoid creating a “flavor-of-the-month” scenario, or a “rubber stamp” process? The answer is simple: accountability. The trick is how to create it. One way involves using social pressure by measuring and discussing results regularly together with key managers. This can take many forms, but it’s critical to have consistent focus around clear objectives.

Does your Company have a spending problem? Reach out to Doescher Group for help.

The Dreaded Budget: Arbitrary Constraint or Useful Tool?

Try to think of something more corporate than a budget. Does the thought of the budgetary process give you anxiety? If yes, you’re probably an owner-entrepreneur.

Budgets are definitive statements about the future. They put your business in a box. You do not like being put into a box. You are an outside of the box kind of person.

In spite of this, I assert that you should embrace the budgetary process. Yes, it can be tedious and time-consuming. But the reward is great for those who treat the budget as more than a mandatory annual exercise for their lender.

The Bad Side of Budgets

One common complaint about budgets is that they encourage the “use it or lose it” mentality, which leads to unnecessary expenditures to preserve one’s budget size for next year. While I have seen this behavior in large corporations, it is far less common in closely held businesses with engaged ownership.

Another complaint I’ve heard is that budgets form an artificial constraint. Once again, I find this to be more myth than reality in closely held businesses. Certainly the budget can constrain spending and force the team to do more with less. But it also can enable collaborative conversation when unforeseen needs arise, leading to better outcomes.

The Good Side of Budgets

I cannot recall the source, but it was once said, “The problem with forecasts is that they’re about the future.” This is true. You will either beat or miss budget, never nail it. That said, the best thing about a budget is that it provides a measuring stick, which can serve an invaluable role in helping you improve your business.

You might focus on up-time, production rates, truckloads, clicks, foot traffic, conversions, scrap rates, or whatever statistics matter for your industry. Yet when it’s all said and done, profit or loss is the measurement that determines business success or failure. So why not monitor progress toward that goal?

By setting an annual budget and measuring actual progress to it monthly, you will discover a lot about where you need to be focusing your efforts. Additionally, this process will make your company more bankable and invest-able, as you are able to discuss and address variances (positive and negative) to your budget in record time.

Need help with your budgeting process? Reach out to Doescher Group to learn more.