How much cash does your business need to survive?
Every business needs a certain amount of working capital to survive. This working capital is used to pay overheads and wages while you wait for your customers to pay you. It’s also used to buy your stock prior to selling it to your customers.
Even profitable business can go under if they’re under-capitalised (which is why builders go under during construction booms). Working out the required level of capital for your business, and having it available, is the key to building a business which doesn’t face constant cashflow pressure.
The amount of capital required for a business also changes over time.
For example (and apologies, this is going to get a bit accountant-like.)
Let’s say your overheads are $10,000 per month, plus wages of $5,000. You buy on average $5,000 of stock per month. If it takes you 2 weeks to sell your stock, and your customers are paying you after 2 weeks, you probably need working capital of $20,000 to keep the lights on (now remember this is very approximate and is simplified to illustrate the point).
Let’s then say you develop a new production process which takes twice as long as previous, but increases your margin by 20%. On the face of it, the increased margin makes it very appealing.
The catch however is the increased length of time it takes to get the stock out of the factory and into your customer’s hands. This means you need more working capital tied up in the business to support the ongoing overheads, wages, and cost of stock etcetera.
If the business has insufficient working capital, it will still have cashflow problems despite the increased profit margin. This is what ultimately causes profitable businesses to fail.
Now even though this is an exceptionally simplified example, the concept holds true for all businesses. It also holds true regardless of whether you’re selling physical product, whether you’re in retail, or even if you’re selling time.
So, what does this mean for you and your business?
It’s critical that you understand the level of working capital your business needs. If you’re under-capitalised then you’re going to feel the pressure of cashflow.
If you’re contemplating making a change to your business (for example hiring staff), it’s important to understand how much additional working capital the change will require.
If you’d like to find out more about how much you need for your specific business, feel free to reach out to iif Chartered Accountants – 04 212 4977, or [email protected]. We’re based in Wellington, but help businesses from Auckland to Dunedin.