Here we must do a little math calculation together to make a point. Assume that your gross margin from sales is 50% for ease in calculation. Assume 30 days to collect receivables from completed work, and 30 days to complete the work. Finally, assume a fixed overhead equal to all of the remaining 50% of revenues, just for the sake of making this point. Zero profit. Now consider an increase in your revenues from $1 million a month to $1.5 million, the extra $500 thousand to be billed in 30 days upon completion of work.
During the first 30 days, you pay out over that period $750 thousand, the fixed overhead and cost of sales. That’s $250 thousand more than last month, putting you in the hole. You bill the $1.5 million on the 30th day and start the clock, waiting 30 days for receipt of the cash. During that time you receive the $1 million you billed the month before but pay out another $750 thousand in overhead for the following month. Where do you sit at the moment before collecting the $1.5 million billed last month? You are down an extra $500 thousand beyond the breakeven amount when you were billing a steady $1 million a month and paying out 50% for cost of sales and 50% for pre-ramp overhead.
[Email readers continue here…] It took your company finding or funding $250 thousand a month for two months to finance an increase of $500 thousand in revenues. Surprised? Most managers are. If the growth continues, the amounts needed just increase and increase, until fixed overhead is no longer such a large part of revenues (growing more slowly than revenues), and perhaps margins increase with buying power and efficiencies of mass production.
With an asset-based bank line and a limit far higher than current need, a company can borrow against those receivables and eliminate at least the second $250 thousand of cash needs, since the receivable “pledged” for the bank line increases by $500 thousand. Most companies have little headroom in their asset-based bank lines, and such expansion of revenues can be accommodated only for awhile before the line is borrowed to its maximum.
Growth requires its own unique form of working capital cash planning. The mere fact of rapid growth is not enough to create capital within most organizations until the growth becomes more stable and receivables collections catch up with costs advanced to the various resources to “buy” that growth.
