Working Capital The Fuel In The Tank

People will tell you that lack of working capital is one of the most common reasons that businesses fail. Buying a franchise and trying to run it without sufficient working capital is like going on a road trip without enough fuel to reach the next petrol station. So what exactly is working capital, and how do you work out what you need?

What Is Working Capital?

When you purchase a franchised business, you’ll first consider the initial capital outlay you’ll need to spend on items such as building fit-out, vehicles, signage, equipment, uniforms and, of course, the initial fee that will give you the right to use the franchise’s system and brand. This is the cost of getting into the business – but it’s not the money you’ll need to run the business.

Working capital is the money that you will need on a day-to-day basis to buy supplies or stock, pay your power bill, meet staff wages and all the other things that a business has to do. When you first open your doors, you are likely to have more money going out than coming in, so you need to have enough funds available to make up the difference. As your business grows, you may have more money coming in than going out but you’ll still need working capital because you’ll need to buy more supplies or stock – in fact, if your business is growing fast, you’ll need more working capital than before to fund the time difference.

How Much Do You Need?

The amount you need depends on a number of factors. For example, is your business premises-based or mobile? Do you mainly make cash sales or do you give customers time to pay? Is it a new start-up or have you taken over an existing business?

In a typical food and beverage business, such as a café, customers pay on the spot whereas the wages and suppliers are usually paid weekly. This type of business is often called a cash business which is defined as having no debtors (customers who pay on credit terms) and little or no stock.

Contrast this to a service business such as building which pays its workers weekly while providing credit to customers who may take six to eight weeks to pay from the time the service is provided. Or a retail business which has to hold stock on the shelves as well as paying rent and wages although its customers pay on invoice.

Here’s a diagram that shows how the cash outlaid to deliver the product or service is finally recovered. As the examples given above show, the amount of time it takes to complete the cycle will vary but whether it’s 20 days or 90 days, the principle is the same.

 

EXAMPLE OF A WORKING CAPITAL WHEEL  OF A TYPICAL BUSINESS

Cash introduced at the start of the cycle is the working capital. Once a full trading cycle has occurred, the cash will be replenished when the product or service is paid for.

Stock purchased. To make sales, you need something to sell. Stock will need to be purchased and suppliers paid, often before you can start to trade. Lead times for restocking and minimum buying quantities are factors to be considered. Franchisors may be able to negotiate better prices and payment terms than independent operators but these still need to be factored in.

Wages paid. Staffing levels of franchises vary enormously from one-man-and-a-van type businesses to food outlets with 10 or more people on the roster. You need to be able to pay them on time, every time.

Product or service created. Capital required will vary according to the type of business you operate. With product business you will need to have stock or ingredients on hand; with service businesses, you may need to hold basic parts, pay maintenance costs, invoice customers, etc.

Customer invoiced. Do customers pay on the spot or on the 20^th of the month following invoice? How many pay even later? Many factors need to be looked at –­ your franchisor should be able to give you representative figures for this particular business.

Remember, it’s not until the money has come in from your customers that you have the cash introduced to fund the next cycle – which is why, if your new restaurant is fantastically successful, then you will need more working capital to fund the purchases for the next cycle, not less. You might be profitable, but profit is not the same thing as cashflow. Even a profitable business can fail if there is insufficient cash to fund its growth.

Finding The Money

Now you have established the amount of working capital you require, how do you source it? That’s up to you, of course, but here are four of the most common techniques:

1.    The owner introducing more cash to the business. This is only possible if the owner hasn’t unwisely committed all his funds to buy the business in the first place.

2.    Borrowing from banks, eg. loan, overdraft or other option.

3.    Using cash generated from the profits of the business.

4.    Releasing funds locked-up in the trading cycle; eg. by reducing money tied up in stock or collecting accounts receivable (debtors) more quickly.

Taking Advice

It’s clear from the above that when you buy a franchise you need to find not just the money to fund the business purchase but to fund its ongoing operation and growth, too. This requires some planning: we strongly recommend every franchisee prepare not just a budget but also a cashflow forecast to determine how much working capital they require, and when.

Preparing these is often a specialised skill and will require engaging a financial adviser or chartered accountant – preferably one with franchise experience who can provide specific insights that are unique to your chosen business. Using a specialist franchise banker will also help and the franchisor should have some helpful input, but at the end of the day it is up to you to make sure you have enough fuel in the tank to complete your journey to business success.

This advertorial is taken from Franchise New Zealand magazine Volume 23 Issue 1

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