My least favorite part of a painting project is figuring out how much paint I will use. I seem to never buy enough. Then, while my brushes, rollers and sprayers are drying, I’m running to the paint store for another gallon. An extra trip and dried-out, useless supplies could have been avoided with a little more careful, thoughtful planning.
Like of running out of paint, many small-business owners neglect the planning required to make sure they have enough cash to sustain their growth. Instead of coming up short, you can avoid the last-minute ineffectiveness that requires scrambling together the resources to keep your business afloat. The key is to understand your cash conversion, or working capital, cycle.
Step 1: Estimate, as best as you can, how much you think your business will grow next year. Be specific about which products or services will grow or shrink.
Step 2: Determine your average working capital. This is the difference between the cash you are going to bring in and the cash you will need to pay out during the same time period. You do this by pulling two numbers from your balance sheet—current assets and current liabilities. Then you subtract the current liabilities from the current assets to find your working capital. Then you repeat this process for other periods to find a reasonable average.
Step 3: Determine your average Days Working Capital (DWC). This is not nearly as complicated as it sounds, and it is vital to making sure you don’t run out of cash. Simply put, DWC is the number of days it takes to convert all of your efforts into cash. Just take your average working capital (as determined in Step 2), multiply it by 365 days, and then divide that large number by last year’s sales revenue.
Step 4: Determine how much working capital you will need to grow. This is easy now that you know your DWC. Just multiply the DWC times your estimated annual revenue (as determined in Step 1), then divide that total by 365 days.
Step 5: Subtract the new working capital balance required to grow from your average last year.
Step 6: Adjust for other cash outflows by adding things like capital expenditures to the new working capital requirement.
Step 7: Adjust for other cash inflows by subtracting things like cash from a new bank loan or investor. The remaining balance represents the amount of cash you need to come up with to sustain your growth next year.
Running the Formula
Let's look at an example. We'll keep it simple with 50 percent growth and nice round sales and balance sheet figures.
Step 1: Last year my revenue ended at $2,000,000. This year I estimate my business will grow 50 percent, or to $3,000,000 in sales.
Step 2: I look over my balance sheet from the last year and determine my average working capital balance was about $200,000. I averaged current assets of about $400,000 throughout the year and current liabilities of about $200,000.
Step 3: To determine my average DWC, I multiply my average working capital of $200,000 by 365 days, then I divide that by the $2,000,000 in sales I had last year. This gives me a DWC of 36.5 days, or just over one month of cash tied up in my working capital cycle.
Step 4: Next, I multiple the DWC of 36.5 days by my estimated sales revenue for the next year, $3 million, then I divide that by 365 days to find that I need $300,000 of working capital to grow 50 percent this next year.
Step 5: I subtract my required working capital from last year’s balance to learn that I need $100,000 of additional working capital to sustain my planned growth.
Step 6: I will need to buy $10,000 of equipment to handle the growth, and I will also need to update my facility with another $20,000, taking my total additional capital requirement to $130,000 to sustain growth.
Step 7: I decide to get a $50,000 line of credit from the bank to help me sustain growth, but it still leaves a shortfall of $80,000. Getting a line of credit that’s too small is like not buying enough paint—I just never seem to get enough the first time, and that always puts me in a tough spot.
Never Run Out of Cash
Now that you know how much additional cash you need to sustain growth, you can find the resources necessary to grow by 50 percent, or whatever your growth rate is, in just one year. You can confidently achieve your growth initiatives without fear that you will run out of cash. And, if you keep your business running effectively throughout the year of growth, your business will likely experience an even higher growth rate in profitability and cash flow.
Read more posts about business growth.