Everyones heard the term going broke, but how many know the term growing broke? Thats what happens when a business grows faster than its capital structure can support.
In effect, the firm grows so fast that it runs out of money. This situation occurs often during boom times when businesses are trying to keep up with rapid growth.
Many business people may be surprised to learn the problem can also crop up during a weak recovery from an economic downturn such as we are now experiencing.
Lets look at the problem and what to do about it.
During this downturn, many businesses experienced a drop in sales and a reduction in available credit. In addition, many owners significantly depleted their cash to stay afloat.
Now things are looking up. Sales are increasing, but credit is still tight, and cash balances are reduced.
Increased sales require working capital to buy inventory, perhaps hire additional employees, and finance operations until the receivables start to come in.
Remember the saying, Cash goes out before it comes in.? This means most businesses must pay for inventory, wages and operating expenses before, sometimes long before, making the sale and collecting the money.
In addition, the desire for more sales can encourage an owner to reduce prices and grant generous payment terms. These actions make the problem worse.
What can you do? Begin by getting a handle on how much cash you need to conduct your daily business at various sales levels.
Adding sales is not your only goal. In addition, you must manage your profit and your cash flow. Calculate your sustainable growth rate, or SGR, the rate of sales growth you can sustain before you run out of cash.
If your SGR is 10 percent, you cannot grow sales at 15 percent unless you obtain additional working capital to finance the additional sales. Determining your SGR is a straightforward calculation. Ask your accountant or adviser for guidance.
You can increase working capital in many different ways. Among them are increasing gross profit margins by raising prices or reducing discounts, speeding up collections, firing low margin or slow-paying customers, increasing inventory turns, negotiating more favorable terms with suppliers, and monitoring overtime pay.
If necessary, you can reduce owner salary and distributions.
Increasing or taking on a bank line of credit directed solely for working capital needs or factoring receivables can provide new cash. Increasing equity by putting money in the business or taking on investors can address long-term capital needs.
All too often, business owners spend time studying their income statement and ignore their balance sheet and cash-flow statements.
The income statement alone will not give you the information you need to manage your working capital.
Calculate your cash cycle to determine how long it takes for a dollar of sales to end up in your pocket.
The recovery is under way. Remember, you want to grow wealthy and not grow broke. Planning can make all the difference.
Bowser@BusinessValueInsights.com. Dan Bowser is president of Value Insights, Inc. of Durango, Chandler, Ariz., and Summerville, Pa.