Working Capital – that cash flow critical to a franchise’s success
Effectively managing a Franchise’s Cash Flow can be the difference between just surviving and thriving as a franchisee. A recent study in the USA found that 82% of businesses that failed, had been affected by cash flow problems.
Working capital is essential for the day-to-day running of your business, but determining the amount of cash flow required to make operations run smoothly every month is not easy. Therefore, you have to learn to effectively manage your liabilities and assets. This will give you a full understanding of the working capital available to you, thus allowing you to use this cash to its fullest potential.
Types of finance required
When starting a franchise, there are two types of finances to consider start-up capital and working capital, or more commonly referred to as cash flow.
This is the money you pay when you buy a franchise. It is used to fund the franchise fee, buy equipment and initial supplies, as well as to rent (or purchase) and renovate your business premises. Start-up capital is also used to pay for any legal fees or permits needed to get the business up and running.
On the other hand, is the money you will need every month to pay royalty fees, business expenses such as monthly rent, utilities, ongoing supplies, and staff costs. Beyond funding your day-to-day expenses, sufficient cash flow can help you:
- Expand facilities and grow a business. If you reach a sales plateau, working capital gives you the opportunity to expand or regenerate your business.
- Manage the impact of unplanned expenses such as power failures, disruptions to your IT or other systems, rising fuel costs, as well as a sudden drop in consumer demand. You will be able to overcome these events as long as your cash flow remains positive.
- Manage extended payment terms from customers. Franchisees have to do what they can to protect their cash flow, which often means negotiating payment terms.
The cost of traditional financing
Financing from financial institutions, such as banks, is widely regarded as an inexpensive and simple way to fund a business. However, there are often hidden charges and penalties that you may not factor into the cost.
Costs can include government fees and taxes, penalties for missing a payment, or for paying early, as well as processing and documentation fees. These costs could add up to far more than just the basic interest charges from the bank.
In addition, franchisees should be aware that traditional financing can carry personal risk, such as putting up collateral, including cash, and assets including property or equipment. If you sign a personal guarantee and your business runs into difficulties, you could lose these assets.
In the current economic climate it is important for franchisees to also examine innovative alternatives.
Determining your working capital needs
Working capital is the amount by which your current assets exceed current liabilities. However, a more useful tool for determining your working capital needs is the operating cycle. The operating cycle analyses the accounts receivable, inventory and accounts payable cycles in terms of days:
- Accounts receivable are analysed by the average number of days taken to collect an account.
- Inventory is analysed by the average number of days it takes to turn over the sale of a product (from the point it comes in through your door to the point where it is converted onto cash or an account receivable).
- Accounts payable are analysed by the average number of days it takes to pay a supplier invoice.
New businesses may have to use industry benchmarks to develop detailed projections aimed at creating a target for their working capital.
Here are some tips to help reduce your expenses, increase cash flow and thereby avoid unwelcome surprises.
Too much working capital can be tied up by keeping a large inventory. The just-in-time model can help alleviate this problem for your business. Supplies and new products are timed to arrive exactly when you need them, thereby avoiding overbuying or the cost of storing large stocks of inventory.
On the negative side, a just-in-time inventory schedule has the inherent risk of you having to wait for a product or component to arrive at the last minute. A back-up plan in case there is of any disruptions in your supply line is essential.
Invoicing, collection and payment procedures
Other ways in which you can free up working capital is to increase revenue and streamline your cash flow. While increasing revenues takes time, you can boost your cash flow relatively quickly.
The first step would be to invoice customers as soon as possible after services have been rendered and re-evaluate how long you are prepared to wait for payment. Waiting 30 days for payment used to be the norm, but in many industries these days, it is not unreasonable to request payment within 15 days. Staggering your payments to suppliers or negotiating more favourable payment terms would also contribute to a positive cash flow situation.
Maintaining a healthy level of working capital requires stringent strategic planning. Carefully considering your capital needs for at least the next year is critical. You also have to fully understand and plan for any upcoming franchise upgrades or product launches, etc. If you experience a slowdown in business on a seasonal basis, it should also be carefully planned for. Your business’ future should be diligently mapped out so that you can source working capital to meet your current needs and have sufficient resources for future growth.
The working capital cycle
The working capital cycle measures the time between paying for goods supplied to you and the final receipt of cash from their sale. This cycle must be kept as short as possible to increase the effectiveness of working capital.
There four core components to the working capital cycle:
- Cash (funds available)
- Creditors (accounts payable)
- Inventory (stock on hand)
- Debtors (accounts payable)
Being in control of each step in this cycle is key to successful cash management. Converting your trading operations into available cash as quickly as possible will increase the liquidity of your business. This will make you less reliant on cash from customers, extended terms from suppliers, overdrafts, and loans.
The right level of working capital
The right level of working capital depends on the industry and the particular circumstances of the franchise. Franchises in the service industry that do not need to pay cash for inventory, need a lower level of working capital. On the other hand, franchise concepts that take a substantial time period to produce or sell a product, will need a higher level of working capital.
It is vital to accurately calculate the correct level of working capital needed. Working capital that is:
- Too high – will mean your business has surplus funds that are not earning a return.
- Too low – will mean that your business may be facing financial difficulties.
The following formula can used to calculate working capital (Note: You will need the figures from your most recent balance sheet):
Working capital (R value) = current assets – current liabilities
However, this calculation will not help you determine whether your working capital safety margin is wide enough. To determine that, you will need to use the working capital ratio (current ratio/liquidity ratio).
Sources of working capital financing
- Equity – If your business is in its first year of operation and not yet profitable, you may have to rely on equity funds for short-term working capital needs. These funds may be injected from your own personal resources, a family member, friend or third-party investor.
- Trade creditors – If you have a particularly good relationship with your trade creditors, you may be able to solicit their help to provide short-term working capital. If you have paid on time in the past, a trade creditor may be willing to extend terms, enabling you to meet a big order. For example you could secure 60-day terms from your supplier if 30-day terms are normally given.
- Factoring – This is a system whereby a bank purchases your franchise business’ debtors book, outlining all the debts with regard to the supply of goods and services, but excludes money owed by private individuals, loan repayments due to the business, etc. Depending on the value of the debtors book and the expected growth of the franchise, as well as its financial management and invoicing systems, up to 80% of the value of debts may be advanced. The balance is retained to cover contingencies. It is similar to an overdraft, but is determined by the value of the debts owed to the business and the limit is thus not fixed.
- Overdraft – This simply means that the bank allows the balance in your cheque account to have a negative balance up to an agreed limit, and you can then use the extra money as required. Strictly speaking, you do not apply for an overdraft, but an overdraft facility. In other words, you are allowed to borrow any amount up to your overdraft limit – therefore there may be times when you don’t use all the available funds. This gives you more flexibility than a normal loan, as you don’t pay the bank interest if you don’t use the overdraft facility. Facility fees may apply.
- Short-term loan – You may also be able to secure a once-off, short-term loan (less than a year) to finance your temporary working capital needs. If you have established a good relationship with your bankers, they may be willing to provide you with a short-term loan.
Don’t tie too much working capital up in inventory
Many franchisees make the mistake of tying too much of their cash up in inventory. This is particularly true of new franchise owners who are still learning about sales patterns. But this is a bad habit you must try not to fall into, right from the start. Here are some ways to control how much working capital you place into inventory:
- Prioritise your orders – When making sales projections, establish the demand for each product. Prioritise your top products and ensure that the required inventory is in stock and reordered frequently. For example, focus on producing an efficient inventory management system for a particular product that produces the majority of your sales.
- Monitor orders carefully – A vital part of managing inventory costs is ensuring the timeliness of orders. Over-ordering inventory will tie up cash, thereby severely affecting your liquidity. For this reason careful projections are essential when it comes to supplies. Using past sales and orders as a reference is the most efficient way.
Working with Your Bank to get Working Capital for your Franchise
When approaching your bank, it’s very important to do your homework and provide them with a comprehensive business plan. At the very minimum, the banker will expect you to provide realistic answers to the following questions:
1. How much money do you need and how much will you contribute from your own resources?
The loan amount you ask for should be “just right”. If you borrow too much, you waste money on interest payments; if you borrow too little, you will soon face a cash crunch, and this could derail your plans.
2. What precisely do you intend to spend the money on?
This is an important consideration for the bank, as it affects the value of the items bought (which can serve as collateral). If the equipment prescribed by your franchisor is highly specialised and does not have an established market, the value that can be realised in a forced sale may well be close to zero.
3. How do you plan to structure repayments to the bank and what alternatives can you offer should the business’s cash flow fail to keep up with ongoing financial obligations?
What the bank would ideally like to hear is that you have put aside a nest egg which you can liquidate should the need arise, or that you have arranged a soft loan facility “just in case”.
4. What can you offer as collateral?
The availability of collateral remains an important consideration. It is a good idea to prepare a list of items you own and are willing to offer as collateral or security for the loan, their realistic market value and how much equity (market value less outstanding finance) you hold in each.
Conclusion of Franchise Working Capital
Of all the mistakes a new franchisee can make, the most fatal is failing to anticipate the cost of staying in business. Therefore, when you begin to explore franchising as a business option, you may soon discover that one of the greatest benefits of this business model is having a franchisor that can help you tackle issues with Working Capital.