All business owners like to see growth at the end of each year. Likewise, they like to see their own compensation increase in line with that growth. Unfortunately, that’s not always the case.
Growing businesses often find themselves in a cash crunch if they grow too quickly without an adequate line of credit to assist with the related increased working capital needs of new customers.
For example, let’s assume a professional services firm gets a large, $2 million per year contract from a major corporation. The contract will require the firm to hire an additional 16 people and the contract is expected to have a 20 percent profit margin. Assuming the 16 hires are billable to the contract immediately upon hire, which is not always the case, below is a brief cash flow analysis:
Cost for each employee (assumes no hiring fees or increase in rent):
New computer with software $3,000
New desk, filing cabinet and shelving 1,500
Business cards, supplies, etc. 100
Total cost $4,600
Number of employees X 16
Total cost for new employees $73,600
Now, the cash required before you collect the billings from the new customer:
Days it takes to bill (assumes bills are completed
by the 15th day of the following month) 45
Days to collect from customer 45
Total days to collect 90
Times daily cost:
Gross revenue $2,000,000
Costs as a percentage of revenue 80%
Estimated total cost $1,600,000
Total days 365
Daily cost 4,383.56
Cash outlay until initial invoice is collected 394,520
Total cash required before first accounts receivable is collected $468,120
Since the contract generates $400,000 per year, it will take about 14 months for this contract to break even from a cash flow perspective (excluding income taxes).
As you can see from this example, a smaller company that does not have access to working capital could be severely strapped for cash if it does not sufficiently plan for growth.
So, if you lead a smaller company, what should you do when a large opportunity arises that you would like to take advantage of? We would suggest considering the following:
- Ask your banker how much they would finance under a line of credit for accounts receivable (billed and unbilled) and whether they would be willing to finance the computers/software and desks.
- Consider getting a retainer from the customer.
- Consider getting accounts receivable insurance on the new customer. If the insurer denies coverage, reconsider whether the customer is worth the risk – there is a reason they were denied.
- Consider billing every week or bi-monthly instead of at the end of the month.
- Consider establishing the payment terms in the contract and verify who should receive the invoice, what support is required, the expected payment terms, and the correct address to send the invoice. If the invoice needs prior approval, find out who that is so it can be expedited.
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