Net Working Capital - The Missing Piece in Your Business Growth Plan?
You cannot believe it. This is cause for celebration! You just pulled in another huge project, this time from a customer you’ve been dying to do business with for the past 18 months. As soon as you are off the phone, you race to share the news with your controller.
“I just booked another multi-million dollar deal, this time with ABC Company! Isn’t that great?”
His response was, “Boss, I’m really happy for you, but we are already out of money. There is no way we are going to be able to pull this all off. I’ve already got vendors hounding me to get current and we’re barely making payroll.”
This conversation has occurred repeatedly for the past few years as you’ve led your company through a period of exceptional growth. You keep signing up really profitable deals, but finance keeps telling you that you’re broke. And nobody seems to be able to explain to you what in the world is going on.
You are stuck in the classic situation of many entrepreneurs: you’ve got a net working capital (“NWC”) problem. NWC is the metaphorical grease that keeps the machinery of your enterprise churning out sales and profits. Yet it is often misunderstood and/or underestimated, especially in growing businesses.
People often joke about how “you have to spend money to make money”. This phrase is often used in the context of 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 NWC which is necessary to assure the machinery can be run.
So what is net working capital?
Defining Net Working Capital
In accounting lingo, NWC 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 people’s 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 NWC is needed to operate effectively. To take a simple example, if your business has one active project, it needs a certain amount of working capital to fund payroll and vendor payments while you await payment from your customer. If you add a second active project of equal size, the need for working capital increases, as your obligations to employees and vendors will expand to deliver two projects at once. This expansion, while profitable, will strain your immediate cash position.
The Misunderstanding About Net Working Capital
When you’re evaluating 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 your certain industry. While margins are a critical consideration for any new business opportunity, it’s also important to evaluate the NWC needed to successfully deliver the new piece of 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 a time sequence, and determine the implications for cash flow. With this type of analysis, you can understand if a project can be self-funded or may require outside capital to successfully fulfill.
Is your business growing? Do you feel like you’re always running out of money despite your continued successes at bringing in profitable new work? If so, you might have a NWC problem. At Doescher Group, we work with business owners looking to cement their legacy and we can help. Reach out to learn more about how we can help you today.
