Working Capital - An Unknown Key to Success

Working Capital An unknown key to success Author: Eva Hukshorn 1

EFactor: An introduc5on •  Founders Adrie Reinders, Marion Freijsen, Roeland Reinders •  Started OHM Inc. in 2004: Business Development for Fortune 2000 •  Serving (mainly) technology companies around the globe •  Goal: assist emerging technology companies in selling their product to Corporates •  In 2007 they wrote a book: The N-‐Factor -  How efficient networking can change the dynamics of your business -  Huge success: no theory, but hands-‐on 5ps & tricks •  Result: EFactor -‐ a social plaTorm for entrepreneurs -  Strategic business networking impacts the future of your business -  Goal: share knowledge, increase sales, decrease costs, find capital -  Mission: increase success of entrepreneurs to start-‐up or accelerate their organiza5on -  In 2012 the new book was launched: The E-‐Factor: Entrepreneurship in the Social Media Age EFACTOR, THE WORLD’S LARGEST ONLINE NETWORK FOR ENTREPRENEURS ON EARTH An online community offering you a network, knowledge, events, and every business resources you need to succeed 2

Eva Hukshorn: An introduc5on •  Work Experience -  Current: Partner EFactor Board of Advisory: TreFoil Energy / CleanDrinks / Global Thinkers / ShowLinq Coach Startup: Bootcamp Amsterdam / New Venture McKinsey -  2009 – 2010: Dutch Bou5que – Marktlink Mergers & Acquisi5ons, Amsterdam -  2007 – 2009: Royal Bank of Scotland – Corporate Finance, Amsterdam -  2004 – 2009: ABN AMRO – Corporate Finance New York, Amsterdam -  2003 – 2004: Accenture – Consul5ng London, Amsterdam •  EducaHon -  1997 – 2002: MSc Economics, Finance – University of Groningen, the Netherlands -  2003: Interna5onal & Asian Studies – Na5onal Sun Yat-‐Sen University, Taiwan -  2009 – 2011: Cer5ﬁed Management Accoun5ng (CMA) – Ins5tute of Management Accountants (IMA), United States -  2009 – 2001: Colloquium General & Modern Art – Academy for History of Art, the Netherlands -  2012: Interna5onal Financial Report Standards (DipIFRS) – Associa5on of Chartered Cer5ﬁed Accountants (ACCA), United States 3

FUNDING TUESDAY, EVERY TUESDAY So what can you expect from us each Funding Tuesday? 1.  Webinars on EFactor on Finance & Funding related topics in the EVENT Sec5on 2.  Blogs & interviews with informal investors and funded entrepreneurs with 5ps & tricks in the BLOGS sec5on under NOW 3.  Finance & Funding related ar5cles on NOW feed 4.  In the Finance & Funding GROUP on our website you will ﬁnd Q&As of the webinars under NETWORK 5.  In the KNOWLEDGE base you will ﬁnd more and more presenta5ons on Finance & Funding related topics, including the webinar presenta5ons 6.  And if you become a VIP MEMBER you will personally be supported on your Finance & Funding related ques5ons 4

Webinar Program Overview 2012 June 19: Business Plan Wri5ng -‐ A Roadmap to Success July 3: Pitching & Presenta5on -‐ 3 Minutes, 1 Impression July 17: Strategy -‐ A Vision for the Future, A Strategy for Geing There July 31: Budge5ng & Forecas5ng -‐ Predic5ng the Outcome Aug 14: Working Capital -‐ An Unknown Key to Success Aug. 28: Capital Management -‐ Playing with Risk Sept 11.: Funding & Investments -‐ Some Sources are More Equal then Others Sept. 25: Valua5on -‐ Art or Science Oct 9: Exit Strategy -‐ Nice to Have or Need to Have? Oct. 23: Bootstrapping -‐ An Alterna5ve Answer to Funding Nov 6: Crowdfunding -‐ The Power of Friends, Family and Fools Nov. 20: Networking -‐ Nice You have 3000 Friends, I have 30 Relevant Connec5ons Dec. 4: Marke5ng & (Social) Media -‐ Noise or Value? Dec. 11: No Sales, No Glory Dec. 18: Most Common Mistakes of Entrepreneurs 5

Working Capital: An unknown Key to Success •  Most underused financial tools by entrepreneurs -  complexity •  The only important financial tool entrepreneurs should focus on. Why? -  Cash is King •  Common used financial drivers are based on revenue -  and if you’re lucky on profit •  The goal of this workshop? -  What is it exactly, which items should be included and which items should not -  How do you measure whether your working capital is at a safe level -  How to use working capital as a funding tool Working Capital is a type of liquidity, closely related to cash. And CASH IS KING! 6

Working Capital: Deﬁni5ons •  Working capital: the amount of capital that covers current assets •  Net working capital: measures the shortage or surplus between the amount of capital available and the current assets •  Current liabiliHes: all liabili5es which support the current (core) opera5ons of the business •  Current assets: part of assets that have the form of cash or that convert into cash within one year -  Internal -  Liquidity -  Reserve -  Security -  External 7

Working Capital: Characteris5cs •  Working capital characterisHcs: -  Short term character -  High rate of liquidity -  Part of core opera5ons -  Balance sheet items •  Working capital implicaHons: -  Frequent decisions -  Working capital items closely related -  Small diﬀerence between present value and book value of items •  Working capital is an balancing act -  Risk vs. return -  Permanent level of working capital vs. temporarily character of current assets 8

Working capital s5mulates the opera5ng cycle •  Short term cash contributes to immediate deprecia5on of short term loans •  Short term loans are quick way of ﬁnancing and launching short term assets 5 1+7 ACCOUNT ACCOUNT CASH PAYABLE PAYABLE 6 2+3 1 4 EXPENSES RAW MATERIALS 2 3 FINISHED GOODS WORK-‐IN-‐PROGRESS 9

Working Capital: Basic Calcula5ons •  Working Capital Current = Current Assets MINUS Current LiabiliHes •  Working Capital Current = -  Account Receivable + Inventory + all other Current Assets directly contribu5ng to daily opera5ons -  MINUS -  Account Payable + Non-‐Interest Bearing Short-‐Term Debt + all other Current Liabili5es directly contribu5ng to daily opera5ons •  The more posi5ve this number, the beper your working capital? NO -  Too posi5ve: Do you have enough cash to pay-‐oﬀ your liabili5es? -  Too nega5ve: Are you in control? -  More important: How does your working capital develop from one period to another? Working Capital is an indicaHon of the operaHonal eﬃciency of your company 10

Working Capital Ra5o’s: Current Ra5o •  Several ra5o’s available to determine working capital level. Most common: -  Current Ra5o -  Acid test / Quick Ra5o •  Current RaHo = Current Assets DIVIDED BY Current -  Goal: are there enough current assets to cover your current liabili5es? -  > 1: posi5ve working capital -  < 1: nega5ve working capital -  Preference: 1.2x and 2.0x -  Above 2.0x – lack of growth support 11

Working Capital Ra5o’s: Acid Test •  Acid Test = [Current Assets MINUS Inventory] DIVIDED BY Current LiabiliHes •  Acid Test = -  Account Receivables + all other Current Assets directly contribu5ng to daily opera5ons, excl. Inventory -  DIVIDED BY -  Current Liabili5es (Account Payable + Non-‐Interest Bearing Short-‐Term Debt + Current Liabili5es directly contribu5ng to daily opera5ons •  Goal: are there enough current assets to cover your current liabili5es? -  More precise then Current Ra5o -  > 1: => good -  < 1: => not good -  Acid test < Current Ra5o => not good 12 • 

Working Capital Ra5o’s: Example BALANCE SHEET ASSETS •  LIABILITIES Fixed Assets 100 Equity 100 Account Receivable 200 Debt 5% interest 250 Inventory 300 Personal loan 200 Cash 50 Account Payable 100 Total 650 Total 650 •  Working Capital Current = Current Assets MINUS Current LiabiliHes -  (Account Receivables + Inventory) MINUS (Personal loan+ Account Payable) -  500 -‐/-‐ 300 = 200 •  Current RaHo = Current Assets DIVIDED BY Current LiabiliHes -  500 / 300 = 1.67x •  Acid Test = [Current Assets MINUS Inventory] DIVIDED BY Current LiabiliHes -  200 / 300 = 0.67x 13

Working Capital: Account Receivable •  Startups: 30% of assets are account receivables •  Transac5on has already taken place => customers owe you money •  Establish a policy around your cash ﬂows: -  Customer type -  Sales process -  Invoice procedure -  Errors & disputes -  Procedure around solving issues 14

Working Capital: Account Receivable Management •  Sales on credit policies should include: -  Decisions on offering trade credit -  Management and monitoring receivable balance •  Reduce risk of non-‐payment: -  Advance payments -  Offset amounts owed vs. amounts due -  Requiring a third-‐party guarantee -  Ownership when paid -  Insurance •  Bad debt? -  nego5ate -  third-‐party collec5on -  budget 5-‐10% write-‐off on Account Receivables 15

Working Capital: Account Receivable Ra5o’s •  ACCOUNT RECEIVABLE TURNOVER = Total Revenue on credit DIVIDED BY Average Accounts Receivables -  Amount of 5me receivables are converted into cash •  ACCOUNT RECEIVABLE DAYS = 365 days DIVIDED BY Turnover Rate -  Days on average to collect our accounts receivable for the year >> 40-‐50 days preferred •  RECEIVABLE TO SALES RATIO = Average Accounts Receivables DIVIDED BY Total Revenue on credit -  Indica5on on how quick sales is converted into cash 16

Working Capital: Account Receivable – Example •  EXAMPLE -  1 Jan.: Account Receivable USD 60,000 -  31 Dec.: Account Receivable USD 40,000 -  31 Dec.: Total Revenue USD 400,000 -  Average Account Receivable USD 50,000 >> (60.000 + 40.000 / 2) -  Account Receivable Turnover : 400,000 / 50,000 = 8.0x -  Account Receivable Days: 365 / 8.0 = 46 days -  Receivable to Sales RaHo: 50,000 / 400,000 = 12.5% 17

Working Capital: Inventory •  Inventory management is last on the to-‐do list of every entrepreneur •  Holding inventory is an opportunity costs and a real cash out •  Management of inventory means: -  Planning -  Budge5ng -  Understanding supply chain •  Pareto rule, especially for start-‐ups: 20% of your inventory accounts for 80% of your revenue 18

Working Capital: Inventory Management •  Different categories of inventory: -  Produc5on supply -  Working-‐in-‐progress -  Finished goods •  Inventory valuaHon: -  Per produc5on category -  Average inventory valua5on -  Different models to value -  Seasonal effect 19

Working Capital: Inventory Ra5o’s •  INVENTORY TURNOVER = Cost of Goods Sold DIVIDED BY Average Inventory -  Average 5me a total inventory is sold per year •  INVENTORY DAYS = 365 days DIVIDED BY Inventory Turnover Rate -  Average 5me goods remain in inventory before being sold •  INVENTORY versus Current Assets = Inventory DIVIDED BY Current Assets -  Percentage of inventory consuming your current assets 20

Working Capital: Inventory – Example •  EXAMPLE -  1 Jan.: Inventory USD 1,500 -  31 Dec.: Inventory USD 750 -  31 Dec.: Cost of Goods Sold USD 6,000 -  31 Dec.: Current Assets USD 8,000 -  Average Inventory USD 1,125 >> (1,500 + 750 / 2) -  Inventory Turnover: 6,000 / 1,125 = 5.3x -  Inventory Days: 365 / 5.3 = 68.9 days -  Inventory vs. Current Assets: 6,000 / 8,000 = 75% 21

Working Capital: Account Payable Management •  Account Payable – the biggest excuse in the book •  Accounts Payable are the reverse of Account Receivable •  Expensive source of funding when not paid in 5me on year basis! •  EXAMPLE -  Discount Account Payable 2% within 30 days -  Your payment awer 50 days -  Cost of delay 20 days (50 minus 30 days) x 2% -  Cost of delay annualized [365 days / 20 days] x 2% = 36.5% 22

Working Capital: Account Payable Ra5o’s •  ACCOUNT PAYABLE TURNOVER = Cost of Good Sold DIVIDED BY Average Account Payable -  Amount of 5mes a company pays of its suppliers during a period •  ACCOUNT PAYABLE DAYS = 365 days DIVIDED BY Account Payable Turnover -  Days on average to an account payable is outstanding before being paid 23

Working Capital: Account Payable – Example •  EXAMPLE -  1 Jan.: Account Payable USD 30,000 -  31 Dec.: Account Payable USD 10,000 -  31 Dec.: Cost of Goods Sold USD 100,000 -  Average Account Payable USD 20,000 >> (30,000 + 10,000 / 2) -  Account Payable Turnover : 100,000 / 20,000 = 5.0x -  Account Payable Days: 365 / 5.0 = 73 days 24

Working Capital = Cash •  Working Capital = Cash Management = Cash is King •  MoHvaHon to hold cash -  Opera5onal -  Precau5onary -  Specula5ve •  Cash vs. current liabiliHes -  Rates? -  How short term? •  Cash is King = Cash ﬂow Statement! Always produce a cash ﬂow statement – especially when a Start-‐up! 25

Working Capital: Economic Cycle •  Economic cycle of your business: 1.  increasing -  Unpredictable plus -  Cash need to support growth 2.  Mature -  Steady returns -  Predictable working capital levels 3.  Declining -  Unpredictable minus -  Cash need to slow down decline or support turn-‐around Source: 2009 DUXNRO Consul>ng Services and Jack Heald: The Entrepreneur’s Guide to Working Capital Requirements 26

Working Capital: Calcula5ng Cash Flow •  Economic cycle of your business: 1.  Cash flow quality -  Excep5onal items on profit & loss statement -  Account Receivable controllable -  Account Receivable Days 2.  Cash flow quanHty 1. Cash Flow Quality 2. Cash Flow QuanHty 3. Sufficient for OperaHons 4. Extra Capital Needed GOOD POSITIVE YES NO GOOD POSITIVE NO YES GOOD NEGATIVE NO YES POOR POSITIVE YES MAYBE POOR POSITIVE NO YES POOR NEGATIVE NO YES Source: 2009 DUXNRO Consul>ng Services and Jack Heald: The Entrepreneur’s Guide to Working Capital Requirements 27

Working Capital: Top Line or Bopom Line Growth •  Determine the status of your company: -  Are you fat? -  Or are you lean? •  Can I grow sales out of current business? -  Yes: how far can you go? -  No: are cost reduc5on possible? •  Again Pareto: 80% of output comes from 20% of input -  Human capital (80% > 20%) -  Business processes (20%>80%) Source: 2009 DUXNRO Consul>ng Services and Jack Heald: The Entrepreneur’s Guide to Working Capital Requirements 28

Working Capital, a form of debt? •  Debt: all outstanding long-‐term interest bearing liabili5es •  Net Debt: all outstanding long-‐term interest bearing liabili5es MINUS cash •  If working capital is cash, is it included in net debt? January Year 5 – DEAL AGREED March Year 5 – DEAL CLOSED Fixed Assets 100 Equity 100 Fixed Assets 100 Equity 100Receivable 300 Debt 250 Receivable 500 Debt 350 Cash 50 Payable 100 Cash 50 Payable 200 Total 450 Total 450 Total 650 Total 650 Purchase price for the share: Company Value MINUS net debt = Equity ValueTotal value of the company 2,000 Total value value of the company 2,000Net debt (200) Net debt (300)Purchase price for the shares 1,800 Purchase price for the shares 1,700 29

Working Capital: Net debt -‐ Example January Year 5 – DEAL AGREED March Year 5 – DEAL CLOSEDWorking capital level of 200 Working capital level of 300 Fixed Assets 100 Equity 100 Fixed Assets 100 Equity 100Receivable 300 Debt 250 Receivable 500 Debt 350 Cash 50 Payable 100 Cash 50 Payable 200 Total 450 Total 450 Total 650 Total 650 No reference made to working capitalTotal value of the company 2,000 Total value value of the company 2,000Net debt (200) Net debt (300)Purchase price for the shares 1,800 Purchase price for the shares 1,700 30

Working Capital: Net debt – Example including Working Capital January Year 5 – DEAL AGREED March Year 5 – DEAL CLOSEDWorking capital level of 200 Working capital level of 300 Fixed Assets 100 Equity 100 Fixed Assets 100 Equity 100Receivable 300 Debt 250 Receivable 500 Debt 350 Cash 50 Payable 100 Cash 50 Payable 200 Total 450 Total 450 Total 650 Total 650 Average working capital level of 250Total value of the company 2,000 Total value of the company 2,000Net debt (200) Net debt (300)Actual WC -/- reference WC (50) Actual WC -/- reference WC 50Purchase price for the shares 1,750 Purchase price for the shares 1,750 31

Working Capital -‐ Conclusion •  Underes5ma5ng Working Capital: -  Growth may be stunted -  Implementa5on diﬃcul5es -  Cash crisis -  Op5miza5on of ﬁxed assets -  Commitment failures Working Capital is a type -  Discon5nuity of opera5ons of liquidity, closely related -  Lack of inventory to cash. And CASH IS KING! •  Overes5ma5ng Working Capital: -  To much inventory -  Too liberal credit terms -  To relaxed management -  Reduc5on Return on Investment 32

Webinar Program Overview 2012 June 19: Business Plan Wri5ng -‐ A Roadmap to Success July 3: Pitching & Presenta5on -‐ 3 Minutes, 1 Impression July 17: Strategy -‐ A Vision for the Future, A Strategy for Geing There July 31: Budge5ng & Forecas5ng -‐ Predic5ng the Outcome Aug 14: Working Capital -‐ An Unknown Key to Success Aug. 28: Capital Management -‐ Playing with Risk Sept 11.: Funding & Investments -‐ Some Sources are More Equal then Others Sept. 25: Valua5on -‐ Art or Science Oct 9: Exit Strategy -‐ Nice to Have or Need to Have? Oct. 23: Bootstrapping -‐ An Alterna5ve Answer to Funding Nov 6: Crowdfunding -‐ The Power of Friends, Family and Fools Nov. 20: Networking -‐ Nice You have 3000 Friends, I have 30 Relevant Connec5ons Dec. 4: Marke5ng & (Social) Media -‐ Noise or Value? Dec. 11: No Sales, No Glory Dec. 18: Most Common Mistakes of Entrepreneurs 33

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Thank you! This document was prepared by Eva Hukshorn. Several people and organizaHons have inspired her to write this presentaHon, amongst which are, but not limited to the Founders of EFactor, ABN AMRO/RBS, University of Groningen, InsHtute for Management Accountants

Working Capital - An Unknown Key to Success

by Eva Hukshorn on Jul 18, 2012

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