The shorter the production and sales flow period the greater the reliance on internal sources of financing. Long production and sales flow cycles depend heavily on external and long-term sources of capital such as debt and third-party financing. This chapter of working capital management explains the two variances and illustrates two extreme production and sales flow cycles. In addition, the matching principle for funding the working capital cycle is analyzed as to the benefits and detriments of using proper working capital financing against inappropriate sources.
This chapter builds on other prerequisite information. Please read the following for preparation:
- Working Capital – Introduction to the term
- Working Capital Cycle – Identifies time frames and relationships
- Working Capital Management – Fundamentals (this is Part I of the Working Capital Management series)
Short Production and Sales Flow Periods
No two business sectors are alike in their working capital cycles. The underlying fundamentals are completely different for each sector impacting the production and sales flow time frame. Application of flat-out statements of general facts is irresponsible. In effect, they are only guidelines. With that said, short working capital cycles are generally less than 90 days in duration. Here are some examples of short working capital cycle sectors:
- Food Service
- Service – Professional, Medical, Labor Intensive
- Entertainment (Localized)
Management of the working capital should match the production/service cycle duration. For example, food service is usually less than seven days for all aspects of delivering meals to customers. Even the payroll cycle is weekly in food service. In effect, the cash flow is instantaneous and therefore self-supporting for working capital management. For operations with short cycles like food service the key is to maintain the working capital balance and plan out the siphoning of funds for fixed asset purchases and payments to owners.
For those operations with 30 to 60 day cycles like service based operations (professional firms, medical practices, cleaning services, temp agencies, and construction trades), accounts receivable management is the most appropriate tool to control cash flow for working capital. I encourage the reader to review the following for greater insight related to accounts receivable:
Those industries with cycle times heading toward 90 days like retail, hauling, utilities etc., resource management generates best working efficiencies. Resource management refers to using the cash to purchase those products or provide services to those customers that WILL pay in a timely manner. Using capital to provide product or services to higher risk customers or products increases the cycle time and overall cost. To illustrate, look at the following examples.
WasteCo is a debris removal service company serving both commercial and industrial sites. The bulk of their services entail providing large waste containers (20, 30 and 40 yard open dumpsters) to construction companies, site developers and specialty projects. The typical working capital cycle includes labor and transportation costs to offload a container at a site. The arrangement with the customer allows the customer to keep the container for up to 40 days prior to billing. A normal time period for use is 22 days and then the container is hauled and a tipping fee (landfill cost) is included in the bill. Processing time for the invoice is about 3 business days. The customer has 30 days to pay their bill.
Total working capital cycle time follows this schedule:
- Initial Delivery of Container – 55 days from start to collection of earnings;
- Rental of Container at Site – 54 days from start to collection of earnings;
- Tipping Fee – 33 days from actual disposal of debris to collection of earnings;
- Driver Payroll and Costs of Haul (fuel, R&M etc.) – 33 days;
- Administration Cost – 33 days;
- Profit Collection – 33 to 55 days depending on the customer’s timeliness of payment.
Thus, the typical maximum cycle time is 55 days with a minimum time of 33 days to collect the earnings. WasteCo is approached by a large potato farm to provide containers and hauling services for the crop yield once a year. The agreement is for 40 containers and approximately 200 hauls to the factory/storage container. The catch is that payment is not made until the farmer is paid by the Co-Op for his share of the total yield. Total working capital cycle is estimated at 110 days, pretty much double the normal time frame. The entire utility period of the containers and hauling is four days.
To address the issue of good resource management and risk starts with the ability of the customer to pay for the services rendered. In this case, the credit check reveals the customer is good for the payment. However, the overall cost will be significantly different as the hauling distance exceeds the traditional distance that exists with ongoing customers. To offset this marginal increase, WasteCo must negotiate a fair price and explain the cost structure to the customer. In addition, WasteCo must consider the loss of existing business for removing 40 containers from the existing pool to facilitate this particular project. Will the marginal gain exceed the marginal loss?
To successfully accomplish this project WasteCo should consider other options including:
- Utilizing a line of credit to fund this project;
- Expanding the existing pool of containers and fleet of trucks;
- Forming temporary alliances (joint ventures) with another hauling contractor to perform the contract;
- Outsourcing the entire contract; AND/OR
- Using analytics to minimize equipment resources for the project.
In summation, outward acceptance of the project without due consideration for working capital resources could jeopardize cash flow and ultimately overall operations resulting in poor profit performance.
Working capital management isn’t a simple formula, it requires some mental thinking and consideration of multiple variables. In this case, WasteCo is no longer financing the project cost with internally generated funds because the cycle time greatly exceeds the normal working capital cycle. Other options must be utilized.
Sometimes the risk isn’t in the customer but in the product.
Bert owns a small hometown hardware store. Bert’s primary competitor is a national chain system store about 10 miles away. Each year in December the various home garden companies present their springtime catalogs for project ideas related to lawn and garden to hardware store owners.
This year a salesman stops in and is pressuring Bert to dedicate floor space and working capital investment for Easter driven products including yard decorations, potted flowers, tree hangers, and chimes. This concept will require an investment of 20% of Bert’s working capital but could yield a 60% profit margin. Any lower investment level into this product line reduces profit margin matching traditional springtime product margins. The alternative is to continue with the tried and true spring product lines of mulch, spring flowers, bushes, yard tools etc. With these traditional lines of products the average margin is 55%. What should Bert do?
To answer this, let’s look at the actual financial result if both options are 100% successful. Assuming the working capital investment is $50,000, the results are as follows:
Option ‘A’ – Invest in the Easter Product Line
$50,000 investment with a 60% profit margin means the investment is 40% of sales. Therefore sales equals $125,000 and profit margin equals $75,000.
Option ‘B’ – Invest in Traditional Springtime Products
$50,000 investment with a 55% margin means the investment is 45% of sales. Therefore sales equals $111,111 and profit margin equals $61,111.
The profit margin between the two options is $13,889.
With this information Bert must consider other possible outcomes including time period for sales. Assuming Easter is in mid April, working capital is tied up from February 1 through mid April or around 75 days. The traditional spring time products have a season from February 1 through mid May, 30 days longer. This provides a unique advantage to the Easter products. Based on prior years, there is no doubt in Bert’s thinking that the traditional product line will sell out. Therefore, the next question is: At what point will the two options equal each other?
Since the marginal profit is $13,889 and this is 60% of Easter product sales, or $23,148. Therefore, Easter product sales must attain a revenue volume of $125,000 less $23,148 or $101,852 to break even with traditional springtime product sales.
Based on this, the investment is tempting because the marginal profit is significant. Bert decides to evaluate risk. He looks at historical patterns and notices sales for springtime products start in late March and peak in mid April. Based on this information, Bert is convinced that he can’t sell all $50,000 of Easter inventory by mid April when Easter actually occurs. People don’t decorate their homes after the holiday. There is no assurance of a complete inventory turnover with Easter products as with springtime products. Worse yet, if his store doesn’t carry the springtime products the customers will go to the competitor to get them risking loyalty.
Bert’s solution is to be cautious and only invest $5,000 of the working capital investment into the Easter product line reserving $45,000 for the traditional springtime products. The margin is the same for both; remember any order less than $50,000 drops margin from 60% to 55%. The risk is significantly less and he brings in some new product for his customers.
With Bert’s Hardware, he is managing the working capital resources to optimize his income and minimize risk. Notice that his production to final sales time frame is almost three months for the springtime products. This has a bearing on his inventory turnover rate and current ratio. But remember, in small business the most important business principle is gross profit in dollars, not margin as a percentage, profit in dollars.
Bert’s Hardware working capital cycle approaches the extreme maximum for the definition of a short production and sales period. Remember these shorter working capital cycles are managed with existing sales and corresponding cash flow from sales. In addition, cash comes from collection of accounts receivable. How are longer production and sales flow cycles managed?
Extended Production and Sales Flow Cycles
When production and sales cycle periods exceed 90 days it is an indicator of long working capital cycles. The primary financing of these longer cycles is internal cash flow. However, outside resources are used to ‘leverage’ production and corresponding sales. The following list identifies some of the industries with long working capital cycles:
- National Entertainment
- Durable Goods (Appliances, Lawn Equipment, A/C Systems)
Each industry uses different tools to leverage up (provide cash) production and sales volume to generate enough profit margin to fund the longer cycles. Here are some the tools:
Line of Credit
This is by far the most common tool used to leverage production. Most lines of credit allow the borrower access to working capital for less than one year. The line is paid back via the proceeds of the sale. Users of this tool include farmers, durable goods retailers and national entertainment (separate lines are established for each concert or entertainment venue).
Factoring is a sophisticated form of accounts receivable management whereby the holder of the receivable sells the invoice for a discounted price and accelerates the cash receipt for the sale. This form of working capital funding is very common in apparel manufacturing and in the garment industry.
To finance inventory with titles (automobiles, marine craft, motorcycles, ATV’s, heavy equipment and large yard/small farm power equipment) dealerships use floor plans. In effect it is a pooled loan with specific equipment/serial numbers as collateral. As each piece is sold, its respective portion of the floor plan is paid back to the lender. As new inventory is acquired, the floor plan finances the purchase price and the collateral is included as security.
Contractors use construction loans to finance each project. As the project achieves incremental milestones the bank funds the completed step thus providing the cash to pay for all labor, materials and subcontractors.
Overall, longer capital cycles use sales flow money and outside resources to augment the cost of sufficient inventory to meet customer demand. To better understand this relationship the reader should read the following articles for a broader comprehension:
To illustrate the above longer working capital cycles, read about how these two companies finance their inventory.
Nailed It Construction
In a typical year Nailed It Construction completes nine customized new home contracts. The typical home sells for $600,000 to $900,000 with costs of $375,000 to $670,000. Each home goes through five distinct phases of construction. The bank allows Nailed It Construction to draw on the loan at each interval. In effect, there are between 40 and 45 draws per year; approximately one draw is taken every nine days. In addition, when the house is closed Nailed It Construction receives its profit. The total number of cash receipts approximate 50 to 55 per year or once a week.
If interested in learning more, visit the Construction Industry page on this website.
Her Day Manufacturing
Her Day Manufacturing designs and makes wedding dresses for the southern region of the United States. Production and the sales period range from five months to as many as twelve months. Dresses are sold in lots to distributors and multiple retail outlet stores. Typical invoices are not less than $22,000 and have 90 day payment options. To expedite payment, Her Day sells the invoices to a factoring finance company at discount rates of 7 to 11% depending on the history of the customer. In effect, Her Day carries very little accounts receivable balance on its books. To reduce the discount rate, some invoices are factored with recourse.
The costs of factoring are structured into the sales price of the dress to the retail stores. The end result of factoring is shortening the production to sales to cash (working capital cycle) by upwards of 90 days.
Summary – Working Capital Management
Working capital management related to production and sales flow should match the time period of the particular cycle. Short periods of less than 90 days rely on internally generated cash from existing sales to fund costs of production and sales.
As time periods for production and sales extend beyond 90 days other financing tools are used to augment cash from sales. These methods include utilizing lines of credit, floor plans, factoring and loans. To be fully successful with working capital management, owners and the leadership team must plan how working capital is used and time the expenditures appropriately. This is explained in Part III of this series. ACT ON KNOWLEDGE.