Archive for March, 2006

Q: How much working capital should my business have?

A: Three months’ worth of expenses is a good rule of thumb for service businesses. Anything less and the business might be just one or two steps away from a cash flow crisis — a big customer doesn’t pay, a major piece of equipment breaks down and needs to be replaced, etc.

Inventory-based businesses might need more or less working capital. It depends on how quickly they turn inventory, their gross profit margin, financing arrangements, and other factors.

To better understand working capital, let’s start with what it is — Working capital = current assets minus current liabilities

You need working capital to pay bills. If your company doesn’t have enough assets to pay off its liabilities, chances are that cash flow is dangerously tight.

You need working capital to borrow money. Sounds funny — you need money to borrow money — but a banker is unlikely to lend your company money at competitive interest rates if s/he sees that a dearth of working capital means you can’t repay the loan.

Note: for purposes of this calculation, include balance sheet items that aren’t technically P&L expenses but still need to be paid out each month. The most common examples: principal portion of loan payments and owner draws or distributions.

Maintain a current ratio of at least 2.0. The current ratio is calculated as current assets divided by current liabilities. This rule of thumb and the “three times expenses” rule above sort of keep each other in check, because if only one of these ratios is strong, the business’ overall financial condition might still be weak.

Finally, QuickBooks will calculate these ratios for you, and does a good job explaining what they are. On the QuickBooks menu, navigate to Company > Planning & Budget > Decision Tools > Analyze Financial Strength.

Each new hire makes a big impact on operations and cash flow. Here are six tips to help the small business CFO do a gut check before adding to payroll.

1. Timing is everything — Marry your sales forecast to your load calculation. How much of your product or service do you expect to sell in the next 3-12 months, and how much can your existing staff deliver? Hire too soon and you’ll drag down earnings with excess capacity. But if you wait too long, you may have to pass on new business - or risk burning out existing staff.
2. Why not subcontract? — Don’t increase fixed overhead with W-2 employees if you can get the job done with skilled contract workers. You’ll pay more per hour, but quickly ramping up or down is less expensive. Abide by labor law, however: many independent contract relationships are really employee relationships. The risks of misclassification - worker’s compensation and unemployment claims, back payroll taxes - aren’t worth it.
3. Calculate retention — Calculate your rate of employee retention: what percent of last year’s employees are still working for you this year? Higher retention means lower turnover, and employee turnover is expensive in terms of recruiting, administration, training, and management. Improving your retention rate increases your return on investment in labor.
4. Layoffs: how low will you go? —Your #1 job as company leader is to protect the long-term health of your business for its stakeholders. We believe that entrepreneurs who plan for the worst actually increase their company’s chance of success by being better prepared to avoid such problems in the first place.Decide ahead of time how much cash you’ll invest in poor financial results before it’s time to lay off employees. Establish your decision-making process of who gets laid off first, being mindful not to discriminate. Be sure that you have a policy on severance pay, even if there isn’t any.Then if you ever do have the difficult task of administering a layoff, follow your plan, then move on and restore your business to financial health.
5. Headcount metrics —Track your company’s headcount, usually expressed as “FTEs”, or Full-Time Equivalent employees (you can include key subcontractors, too). One person working 40 hours per week equals 1.0 FTE, while two people working 20 hours per week each also equal 1.0 FTE.Then, track revenues and earnings per headcount. Compare to others in your industry.Take it a step further and calculate salaries and wages as a percentage of revenues. Normalize for owner and officer compensation to remove the effect of salaries related to tax strategy and management bonuses.
6. If you bill by the hour — If you bill by the hour, these two metrics go hand in hand to track labor profitability:Billable hours. Divide all hours spent on client work by total hours worked. Express as a percentage. You can calculate for one employee or your entire firm. All things being equal, the higher the better.But all things are not equal, so track realization rate (RR), too. RR = what you actually bill divided by what you “should” bill a client if you got paid full rate for each billable. Example: your bill rate is $150 per hour, a consultant works 10 hours, but due to inefficiencies you can only bill $1,000. Your RR = $1,000 / (10 hours x $150/hour) = 67%.