Can your business finance its rebuilding as we emerge from the long era of COVID-19 lockdowns?
As we finally move out of this prolonged period of lockdowns and border closures, many businesses that have experienced a fall in revenues will be able to start rebuilding their businesses back to pre-coronavirus levels. But how many of these businesses are fully aware of the “cash trap” they are facing? And how many have a plan for financing their businesses as they try to overcome this “cash trap”?
The sad and ironic reality is that many businesses will have survived the two years of lockdowns and border closures, only to collapse as they get back to “normal” business conditions. This article provides a clear pathway for enabling your business to negotiate its way out of this high-risk period.
This article looks at:
- The hidden cash trap – the threat to your cash reserves?
- What are your financing needs?
- What are your financing options?
- How will you manage your cash?
The Hidden Cash Trap
In many circumstances It can be easier to manage cash during a period business decline than it is to manage cash during a period of growth. During a period of decline the working capital needs of the business are likely to fall. This releases cash from working capital into the trading accounts of the business. The business is likely to be reducing costs during this period as well so as not to use up cash reserves that provide a buffer for the ongoing needs of the business.
Rebuilding your working capital investment
Many established businesses have spent years building the investment in their working capital. Some of this time would have been painful as the business was forced to reinvest profits into their growing working capital investment.
So, what is the “cash trap”? At a basic level, working capital is represented by debtors, inventory, and creditors. An example of how a period of decline followed by a period growth creates a cash trap is shown below
Period prior to decline
- Debtors $800,000
- Inventory $450,000
- Creditors $250,000
Investment in working capital $1,000,000
Period after decline
- Debtors $400,000
- Inventory $250,000
- Creditors $150,000
Investment in working capital $500,000
This shows that the period of decline reduced the investment in working capital by $500,000. This figure represents cash that has been returned to the bank account of the business. This would have happened over a prolonged period of time and the source of this cash may not have been recognised by the business managers..
The “cash trap” is partly driven by the fact that, as the business returns to pre-COVID levels, it will need $500,000 of additional funds to re-finance its working capital needs.
Things can be a little more complex. We would expect that there will be higher levels of slow paying debtors and bad debts because many of the debtors sitting in the receivables ledger of these businesses are experiencing similar “cash trap” exposures. The rebuild could also be made more complex as suppliers of goods and services experience capacity issues and you find that you need to source from other suppliers where pricing and quality are not fully assured.
Rebuilding capacity
As business conditions worsened, many businesses would have reduced their investment in capacity. This includes letting staff go, selling equipment and motor vehicles, and cancelling subscriptions, insurance cover, and a range of other costs. As the business starts to return to previous business levels, it will need to reinvest in capacity to enable it to deliver the goods or services at the previous levels.
Many established businesses have spent years building the investment in their working capital.
Resourcing the increased personnel needs will include the costs of recruitment, induction, and training. On top of the measurable costs, the hidden costs are lower productivity from the new personnel and lower productivity from the teams around them as they support the development of the new team members.
The other costs involved in rebuilding capacity will vary with the type of business, but they will be there. This will include a range of costs such as recommissioning production lines, purchasing new warehouse equipment, scaling-up sales, and operations planning processes.
Returning to previous profitability levels
The costs involved in getting back to the earlier profit levels will be further added to by a range of other factors. A range of overhead costs will increase ahead of the return to profitability. This will be a one-off impact on cash, but it is real and will demand funds from the business. An example of where this could be significant is sales and marketing. Businesses with interstate or international customers who they have not been able to visit regularly over the recent period may need to intensify interstate or international travel. Promotional campaigns may be ramped up to guard against losing market share as demand returns.
What are your financing needs?
Understanding what your financing needs are and what the business is actually financing is an important consideration. This article will summarise the approach for understanding this on an ongoing basis in the last section. In essence, the business will need to finance the following areas.
Working capital
As described earlier in this article, the business will most likely need to fund the increased level of working capital. It is important to know what level of finance is going to be needed to cover this. The investment in working capital may continue to increase over a period of time. Working capital finance facilities can be arranged to cover the increases and falls in this area.
Capital investment
Investment in equipment and other productive fixed assets is generally easier to finance through asset finance products. Understanding the financing need in relation to the capital investment is much more straight forward. However, the business needs to understand the useful life of the capital equipment and be clear that financing products have appropriate terms and that any balloon payments at the end of loan periods are not excessive in relation to the likely resale value of the equipment at that time.
Other business costs
Other costs involved in growing the business are more difficult to finance. This might include funding the business through a period of losses before it returns to profitability, or the costs involved in restructuring or relocating business operations. This is more appropriately financed by equity. Debt finance can be an option although this is likely to require additional security.
Some businesses may also want to finance acquisitions during the growth period. A business acquisition will include some tangible assets (eg: plant and equipment, inventory, etc) and some intangible assets (eg: goodwill). This could be funded via a range of finance options matched to the different components of the acquisition.
What are your financing options?
As stated earlier, it is important to match the type of finance to the finance need. A proactive approach to this will result in the best outcome for the business. This requires the business to have a good understanding of what the likely needs will be and start the process of putting the facilities in place early. The best outcome is unlikely to be achieved where the business is seeking finance on an urgent basis
Working capital finance
A range of working capital finance products is readily available. This includes invoice financing, single invoice financing, trade finance, and supply chain finance. The appropriate type of finance will depend on the nature of the working capital components.
The cost of the various funding options involves more than just the interest rate. Administration costs are particularly important when looking at working capital finance. These products generally have significant administrative demands (ie: costs) so it is important to put a key focus on these administrative costs before deciding on the appropriate finance product.
Capital investment finance
This is generally the easiest area of finance to access. Once these loans are in place, the administrative costs are reasonably low. Lenders will require security over the equipment and often will take security over the chattels of the business. Also, lenders may impose covenants, and this will add some reporting requirements to the business.
Commercial loans
The options will range from fintech companies that provide operating finance and link to cloud-based accounting packages; to banks providing products including overdraft facilities to secured commercial loans.
Retained earnings
The options will range from fintech companies that provide operating finance and link to cloud-based accounting packages; to banks providing products including overdraft facilities to secured commercial loans.
Equity
This is a good option for funding the general business growth needs. However, unless the existing owners have private funds to invest in the business, this will involve a reduced ownership level and some loss of control. Outside of the existing shareholders/owners ofthe business, the other options include private equity or other individual Investors.
How will you manage your cash?
Understanding the future cash needs in your business, accessing the appropriate finance sources, and managing the cash reserves of your business through the growth period will be essential elements of rebuilding or growing your business. So how do you determine your cash needs and how do you maintain a healthy cash position throughout the growth period? The management activities that will accomplish this are also the activities that will demonstrate to lenders that your business is a low-risk borrower and will make the financing process more straight forward.
… lenders may impose covenants, and this will add some reporting requirements on the business.
Planning
The planning process is a critical requirement for establishing the cash needs of the business. The business needs to have a well-developed forecasting process in place. This includes a full 3-way process of forecasting operating profitability, forecasting balance sheet movements, and establishing the impact on cash requirements throughout the forecast period..
This requires a good understanding of the drivers of revenue and cost in the business, and a detailed plan around the changes to the balance sheet that will impact on cash in the business. The historical accounts provide a guide to many of these behaviours, but a clear understanding of the strategic plans of the business is a requirement for building a meaningful forecast.
Key elements in the 3-way forecasting process will include:
Operating profitability
| Forecast sales | Where product categories, key customers, territories, and channels have an impact on volumes and margin, these should be included |
| Forecast cost of sales | The issues that will impact on margins need to be included. The mix of sales is one issue, but productivity or input cost issues will also need to be included |
| Overhead expenditure | What are the plans for overhead expenditure? Will sales & marketing strategies be more intensive? Will additional staff be required? |
| Other income/expense | If other factors will impact on cash, they should be included as well. This could include costs such as redundancy costs or relocation costs, or income from a grant or insurance claim |
Balance sheet movements
| Working capital | What will be the level of receivables outstanding? What level of inventory will be needed? How much of this will be offset by an increase in payables and other payables balances. Will there be other current assets or liabilities to be considered? |
| Fixed assets | What investment in plant & equipment will be required? Will there be a need to invest in more vehicles? In addition to these, there could be other non-current assets that need to be funded through means such as security deposits or bank guarantees. |
| Financing | This includes meeting existing finance commitments but will add any proposed financing arrangements as well. Existing loans may include significant balloon payments at the end. All of these will need to be included. |
| Other | This can include related party and intercompany loans or other non-standard assets or liabilities. |
Financial Control
Having strong financial controls is another essential element for achieving reliable forecasts. As stated earlier, the historical accounts provide an important guide to forecast assumptions. If the business’ accounts are not reliable, this will mean the business could be getting misleading guidance to its future performance. A strong indicator of weak financial controls is gross profit margins that vary significantly from one month to the next. This is generally caused by not recognising revenues and costs in the correct periods (the matching principle).
The balance sheet often hides some key issues for the business. Large cash inflows or outflows can be driven by balance sheet movements and so it is very important to ensure the balance sheet accounts accurately reflect the real values of assets and liabilities. Introducing a regular regime of undertaking balance sheet reconciliations will ensure strong financial controls.
Reporting and review
Once the business has strong financial controls and can rely on the accounts, the reporting and review processes will become more powerful. For example, a fall in gross profit of 2% to 3% could flag the need to take corrective action to address an emerging problem in the business. But if the business is reporting wildly inconsistent gross profit margins, management will not recognise that there is an emerging problem that needs their focus..
With Australia nearing the point where it will start to emerge from the recent State imposed constraints, many businesses need to get ready to return to previous levels of turnover (or higher). They must ensure that they will have sufficient cash to navigate through this period. Managing this growth will take all the focus of management. The last thing management needs is to be dealing with distractions and issues caused by having insufficient funds.
The steps to ensure your business can get back to pre-covid levels successfully include:
- Develop 3-way forecasts support by historical accounts and clear strategic plans
- Ensure you have strong financial controls that ensure financial performance is well understood and continues to support the assumptions in the forecasts
- Ensure performance reports are accurate for the reporting periods so that management will recognise any divergence from the plan and can address issues as they emerge rather than after they have done serious damage
- If the forecasts reveal the need for business funding, arrange this in advance of the requirement. It will be much easier to pre-empt this need before it occurs, rather than in the middle of a cash crisis.
The Virtual CFO Group Australia have well developed financial control processes that it uses with a range of clients. These have been developed for a range of business types whose operations include manufacturing, service delivery, 3PL and wholesale/retail both within Australia and internationally.
These processes have helped many finance teams to establish more reliable reporting and review environments that support productive decision-making.
The Virtual CFO Group Australia has well-developed financial control processes that it uses with a range of clients. These have been developed for a range of business types with operations that include manufacturing, service delivery, 3PL, and wholesale/retail – both within Australia and internationally.
These processes have helped many finance teams to establish more reliable reporting and review environments that support productive decision-making.
