Between Stonewood Homes, Call Active and Dick Smith, it seems like there’s a significant business falling over every few weeks. While each business fails for different reasons, often its due to them being under capitalised.
Before jumping into it, a quick recap on the difference between cashflow and profit – Without getting into too much detail, cashflow looks at what you’ve spent cash on, and who has paid you cash. Profit looks at who you’ve promised to pay, and who has promised to pay you.
This is where a business’s capitalisation is important. Successful businesses need sufficient capital so they’re able to withstand a promised payment not turning into cash. If they can’t withstand payment not coming through, then the inevitable happens – they may be able to overcome the shortfall in the short-term, but not forever.
This is exactly what kills a number of builders – the profit from one job is ploughed into materials for the next job, payment on the next job is held up, then before they know it, the stack of cards come tumbling down.
This raises the question of what a sufficient level of capital is for your business. There’s a range of industry “rules of thumb” out there (like 2 to 3 times OPEX in your reserve account), but ultimately it comes down to the nature of your business. An accountant for example might have two months’ wages and rent in reserve, while a manufacturer might have enough for three months of stock purchases together with two months’ expenses.
Ultimately you need to have enough in reserve to sustain a promised payment not arriving. That number can only be calculated by working through your cashflow cycle, your monthly expenses, and your appetite for risking it.
If you’d like to find out more, we’re running a seminar in April on the cashflow cycle. If you’d like a spot (5 left), feel free to let us know.