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Strategic Thinking About Working Capital for Owners of Private Companies


By Michael Spence, BPM Shareholder
September 1, 2011


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Joe White builds a medical practice that thrives despite challenges from skyrocketing insurance costs and managed care cutbacks. His talented med school colleague Jane Black builds a similar practice that struggles and eventually goes belly-up. The difference? It could be how they handled working capital - the single most important factor in running a financially successful company.

Focused on day-to-day operations, many entrepreneurs assume they've taken care of their capital needs once they've nailed down a line of credit. But there's more to working capital than that. Thinking strategically about working capital will allow you to:

  • Predict your financing needs and choose the best kind of financing for your situation.
  • Understand how much profit you can safely take out of the business for personal use.
  • Know when you may need to put cash back into the business.
  • Build a stronger and more valuable company that can provide your retirement nest egg, as well as a secure future for your heirs.

Through thirty years as a business advisor, I've helped numerous clients think strategically about working capital. Here's what is typically involved:

1. Historical analysis and forecasting.
We start by identifying the unique operating cycle of a business - maybe 30 days for a service business that gets paid quickly, maybe six months for an importer who has to order inventory long before any sales are realized.

Using several years of quarterly financials and tax statements, we track the peaks and valleys of the business. Then we apply a proven financial model to estimate the amount of working capital needed to operate securely through a complete business cycle. That allows us to forecast the company's capital needs going into the future.

About nine out of ten companies are undercapitalized but do not realize it.

2. Optimize financing.
Based on this analysis, we review the client's current financing arrangements - equity, lines of credit and term loans, short-term and long-term borrowing. Understanding the size and timing of your capital needs can often allow you to save money or gain flexibility.

In one case, an auto parts distributor was on his bank's "watch list" because of a hefty $4 million line of credit to pay his overseas suppliers. Through analyzing his business cycle, we realized that he really only needed about $2 million for six months each year. We helped him turn $500,000 of that short-term debt into a term loan, and decreased his remaining short-term debt to a $2 million line of credit that would rise to $3 million during the period he needed it most. His debt ratios improved, the bank's concerns were alleviated, and he was able to focus on expanding his product lines and retailers.

In another case, a construction business that relied on a lot of heavy equipment was paying $75,000 a month in debt service on a term loan of $3 million. Through a working capital analysis, we were able to convince the bank to restructure the loan so payments dropped to $40,000 a month. The owners plowed those savings back into the business, and within a year increased the cash on their financial statements from $100,000 to $450,000. The business owner got some much-needed breathing room, as well as cash reserves that meant less borrowing for his next equipment purchase.

3. Strategize to retain profits in the business.
It can be tempting to take most or all of a company's annual profits for personal needs such as housing, vacations, and children's education.

But retaining some profits as working capital - or even plowing in some of your personal funds if necessary -- can strengthen and increase the company's value in the long run. Lenders are more likely to extend credit if a company is well capitalized and if the owner has invested his or her resources. That can prove invaluable when your firm hits a rough spot or needs additional capital to take advantage of a business opportunity.

Of course, plowing profits back into the business takes personal discipline. And many business owners resist showing profits on their books since they don't want to pay income taxes.

But a little pain today can lead to greater gain tomorrow. And a good financial advisor can help identify strategies to minimize tax liability while returning profits to the business. For instance, manufacturing companies can time major equipment purchases to offset profits: Deducting $300,000 for a new piece of machinery can reduce $500,000 in taxable income to a more manageable $200,000.


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Taken together, these three steps can sometimes mean the difference between financial success and failure.

That was the case with one of my longtime clients, a medical practice facing a challenging transition into the era of managed care.

The practice had been owned by a group of older doctors who made a handsome living from it for years. Their tradition had been to distribute all the profits through year-end bonuses to themselves, along with an employee profit-sharing plan. They typically ended up taking home $350,000 to $500,000 each.

When it was time to retire, they sold the practice to a group of younger doctors. But this was just when managed care was taking hold and insurance companies were clamping down on doctors' compensation. Profitability was dropping. And the new owners were funneling what little profits existed into payments for buying the practice. There was a real risk of the firm going under.

Analyzing the finances with our working capital formula, it became clear that the new owners did not have nearly enough capital invested in the business. With our guidance, they made some tough decisions:

  • The new owners each invested $50,000 in the practice.
  • The former owners - who were committed to helping the next generation succeed - loaned $75,000 back to the business on favorable terms.
  • The practice decreased the size of its bonuses. It discontinued the profit-sharing plan and shifted to a 401k plan where employees make their own retirement contributions.

As a result, retained earnings grew from negative $100,000 to positive $300,000. The practice accumulated enough capital to pay back the original owners. Now, if it ends the year with $500,000 in taxable income, it might pay out $300,000 in bonuses to the owners while reinvesting the remaining $200,000. This provides capital for necessary expenditures like a new electronic billing system. The owners are building for the future, while decreasing their need for outside financing.

Those were painful, difficult decisions for the doctors. But they allowed the practice to survive at a time when many others were shutting their doors.

Let's hope your business isn't facing the same sharp external pressures as that medical practice. But chances are that you would still benefit from a strategic review of your working capital needs.

The way to start is with a trusted financial advisor - someone who understands working capital and sees the long-term picture, not just your immediate situation. Your banker or a fellow business owner may be able to make a referral.

With strategic counsel and your own willingness to confront tough decisions, you'll build a more secure and valuable company - one that can survive downturns, seize opportunities, and meet your personal financial goals for years to come.


This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.