Having worked most of my career in the agribusiness field, I have found the ‘Limiting Factor’ theory applicable to many areas of business. The ‘Limiting Factor’ is a simple concept. A plant needs many different types of nutrients (food) to grow. You can supply all the nutrients it needs, except one. Without that one, the plant cannot grow, in spite of everything else having been done correctly. So all the other things you did right, they do not count! The same with cash. No money, nothing else really matters.
Even large businesses struggle with Working Capital needs
If the entrepreneur is the heart of the business, cash is the blood. Lack of working capital is not just a start-up issue. It confronts owners everyday, in spite of our low interest rate environment. Where are the money ‘pits’ that working capital is usually trapped?
- Accounts Receivable
- Fixed Assets
The pits mentioned above are, by no means, all of them but are generally the largest ones. In future posts, I’ll talk about how a business can do a better job of managing their liquidity. Ask yourself, is your banking arrangement facilitating your ability to grow your business, meet payment deadlines and invest in the future? Just because you’ve done business with them for the last ten or twenty years does not mean you should be comfortable. Do you have just one lender? Should you?
The Cash Conversion Cycle
Simply put, the Cash Conversion Cycle is a measurement of how long it takes to convert the dollar invested into inventory back into cash. Accounts payables affects the ratio as well. You can probably find a more detailed explanation by googling it. Many business owners understand that money tied up in Accounts receivables and inventory must be freed up as quickly as possible to continue financing the business. Obsolete or damaged inventory takes up space and is no longer worth its original cost. Accounts Receivables moving well past terms are problematic and may indicate you won’t be turning the receivable into cash as soon as you had expected. A/R and Inventory are areas that owners and managers must be vigilant about. Fixed Assets present a somewhat different issue. There are really two types of assets – those that can directly produce income and those that do not. For instance, a new (or used) delivery truck in addition to the one you have is an expansion. If the truck has been added to service new accounts, and generate new or additional business, then that asset has income producing properties. However,a fancier car for a manager or owner rarely translates into additional, measurable income for the company. Unless the company can clearly afford such a fixed asset investment, non-income producing asset expenditures should be avoided.
Unless your company is rolling in money, paying attention to cash flow should be a top priority. More on this subject in future posts.