Is Your Business Undercapitalized?

Capital is the money that kick starts a new company undercapand provides for equipment, offices, and expenses until revenues grow and takeover the funding of the company operations. Capital is not only needed for new companies but also for existing businesses as they elect to invest in new products, replace aging equipment or to ride out economic storms. Management of “capital” either funded internally by positive cash flow, externally through bank loans, or investment by internal or external partners, is a primary responsibility of the senior executive or owner.

What is undercapitalization?
A company is under capitalized when it does not have sufficient capital to conduct normal business operations and pay creditors. This can occur when the company is not generating enough cash flow or is unable to access forms of financing such as debt or equity. If a company can’t generate capital over time, it increases its chance of going bankrupt as it loses the ability to service its debts. Undercapitalized companies also tend to choose high-cost sources of capital, such as short-term credit, over lower-cost forms such as equity or long-term debt.

Unfortunately it is not uncommon to discover that many small to medium size businesses are undercapitalized or cash starved. The owners probably don’t realize it (or admit it), have accepted the low level of cash produced, and write it off to the competitive market that they participate in. While they are able to meet their living expenses, many areas of their operating expenses and other resources (staff and expertise) are not sufficient to address the economic and market challenges of the company.

How do I know if my company is undercapitalized?
There are a number of asset to liability ratios that are industry standards used to evaluate the financial strength of a business, particularly when it is applying for a short or long term loan. The bank will want to measure the ability of the business to meet the obligations of the loan agreement.

Other measurements would be the amount of cash that the business produces from normal operations. Many businesses are able to finance growth internally due to the excess cash flow it produces and therefore does not need to incur a bank loan or external financing to grow. The business has a positive cash flow if the liquid assets (typically cash) produced by the business exceed obligations (payroll, purchases, rent, loans, taxes, etc.).

A measurement that is more difficult to make is the “freeboard” (excess capacity of the organization to respond to unplanned demands) of the organization to manage the business efficiently and competitively. An organization that has the flexibility to absorb unplanned demands while continuing to meet normal responsibilities will be more resilient and competitive in the marketplace. If the right people and the business processes that they are using are not aligned properly or in enough supply (number of people and expertise) then the business may not have the “freeboard” or be in a strong position to take advantage of market opportunities, or to maximize those that it serves.

If you regularly find your self “robbing Peter to pay Paul” in order to:

  1. Meet your obligations,
  2. Shoring up your cash position with expensive short term loans, or
  3. Provide either limited or no response to market opportunities, address internal business issues or meet the increasing need to serve the customer due to the limitations of your organization or business processes.

Then your company is undercapitalized.

What do I need to do?
To solve an under capitalized condition, the cash position and strength (organization and processes) of the business needs to be improved. The first step is to understand the “Cash Flows” in your business. The next is to examine how you are operating and its affect on cash – either contributing or consuming.

  1. Is your collection process operating properly, do you have too many accounts that are aging which raises questions about the payment terms and conditions that you extend to your customers?
  2. Are payables stretched without incurring interest or penalties?
  3. Are you taking advantage of purchase discounts?
  4. Do you have your cost structure under control?
  5. Are your products and services delivered within budgeted or quoted labor and material content?
  6. Are your products and services producing the minimum operating margin?
  7. Are sales or distributor discounts at budget or out of control?
  8. Are customer returns excessive and why?
  9. Are you getting a minimum return on investment on capital-intensive lines of business?
  10. Does your staff review operating procedures on a proactive basis or are they in a reactive mode barely able to service the minimum needs of the business?

Successful cash management of any business requires a forward-looking attention to detail as each accounting period is completed. Just looking at the bottom line is not the primary measurement of cash preservation or creation.

Each of these factors, and there are more, influence how the business is operating and determine if the business is optimizing (possibly maximizing) the amount of cash that is produced by the business. When a business process is not in control (invoicing is late, payables are not being stretched, too much inventory is on hand for the level of business) then the cash available to the operations of the business decreases and can interrupt other critical operations.

If invoicing falls below budgeted levels, either due to lack of business or not invoicing on time, then this can affect payment for critical inventory, which will lead to a stop shipment by critical vendors. Material is not delivered on time will further affect the ability of the business to ship product and invoice customers. In short order, making the payroll becomes problematic if the flow of money into the company is interrupted.

A business can work through a tight period by using a line of credit at the bank but this incurs a cost, which also consumes cash. If the line of credit is exhausted due to other demands, then more expensive measures may need to be taken that may lead to the owner giving up a portion of the company at a distressed price to an investor in order to bring cash into the company. Additional cash may solve an immediate problem but does not guarantee that cash flows are better.

The best solution is to solve the cash problem internally. There are most likely glass ceilings that the owner and organization have gotten used to. Glass ceilings are unseen barriers in the business that have become, over time, the acceptable limit of what can be accomplished. However, when they are analyzed and the limits challenged, opportunities to operate more effectively, increasing performance to a higher limit emerges. Using an outside consultant will also provide a fresh perspective that will identify areas of the business that can more effectively producing cash for the business.

Attitudes and processes will need to change, but as the business produces more cash it gains flexibility. The business can be managed more strategically than having to be constrained by cash related imperatives. Cash creation and preservation is important for business flexibility.

The vitality of a business is dependant upon its ability to

  1. Produce enough cash to meet the current and future needs of the business,
  2. To have a high caliber organization and
  3. Effective business processes.

Owners and senior managers need to devote a significant amount of their attention to business decisions that will affect these three important areas of the business.

The core issue is optimizing the cash flow of a business to meet current and future needs to avoid the business atrophy. An under capitalized business that does not focus on building cash flow will not have a competitive business strategy that is able to invest in building market competitive products and services, a high caliber organization and effective business processes.

If you are undercapitalized make the decision today that your are not going to just get by. Put a plan in place today to build your cash flow so that you can employ strategies to strengthen your company and be more competitive.

Author’s Note:

I recommend the following articles to expand your understanding and knowledge of how to successfully manage cash flow.

  1. Cash Flow: It’s Dynamic, Not Static
  2. Avoid the Downside of Cash Flow Modeling Your Business
  3. Cash Flow Modeling: An Early Warning System to Manage Business Financial Health
  4. 5 Principles to Managing Cash Flow Successfully
  5. Cash Flow Planning and Profits

Please contact me if you would like to discuss how to design and implement a cash flow strategy in your company.

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