Working Capital And Its Impact On Your Company

[00:00:08.340] - Rich Veltre

All right, sports fans, welcome back to another episode of Books and the biz. I'm Rich Valtry and I am here with my good friend, Dan Paulson. Hey, Dan, how are you doing?

[00:00:22.160] - Dan Paulson

Hey, Rich, I am doing wonderfully. That is an excellent announcement, by the way.

[00:00:28.790] - Rich Veltre

I try every once in a while. Like I said, the accountant, you got to liven them up somewhere in this thing. That's right. Anyway, I really wanted to talk to you today because I have a couple of examples that they're eating at me and they come from the merger and acquisition world. That gives me a little bit of a spark, a little bit of pep in my step. Then I run into these two cases and I go, Wow! Mergers and acquisitions should be exciting and a lot of stuff going on. I think what I ran into is a little bit of what I'll call the aftermath. I'm trying to get my head around it and I could really use an operational perspective when I throw this out there. I hope you're ready for me today.

[00:01:17.150] - Dan Paulson

I am ready, willing, and able because we did touch on this a little bit beforehand. But tell the audience what exciting things are we going to talk about with finance today?

[00:01:29.090] - Rich Veltre

I am a big proponent of watching the merger and acquisition market, especially the small and middle-market companies that are going through transactions. One of the things that I love to see is when there's an entrepreneurial spirit going into taking over a company that might be a little older, might need some freshening up, but it's been around forever, has a good reputation, and maybe owned by a baby boomer, because we said in one of our past episodes that I think there's like 10 million US businesses that are coming up to the point where it's owned by a baby boomer who probably wants to talk about retirement.

[00:02:09.760] - Dan Paulson

That is correct.

[00:02:11.090] - Rich Veltre

So I see a bunch of these transactions happening where company comes in, got a younger guy, wants to get an SBA loan or some other type of financing, wants to buy a business and go into entrepreneurship. Well, there's this little concept that I think some of these entrepreneurs are missing.

[00:02:29.780] - Dan Paulson

And- And maybe some business owners, too.

[00:02:33.030] - Rich Veltre

Well, yeah, I think you're 100 % right on that one. I'm looking at it solely from the transactional standpoint. But you're right, the business itself needs to understand the concept, which is the concept of net working capital. I believe if you go into a finance book and you look up what is networking capital, it's going to tell you it's your current assets minus your current liabilities.

[00:02:59.700] - Dan Paulson

Simply that- Actually, I have a website here. Do you? I do. All right. Let me pull it up. In fact, I think if you look right at key takeaways there, because this article is based on what does slow working capital say about your company's financial prospects, right there, there you have it, working capital, the difference between current assets and current liabilities on a balance sheet.

[00:03:27.260] - Rich Veltre

Yeah. And if you dig a tiny bit deeper, which probably isn't in there, but if you're analyzing working capital, what you're trying to figure out is, can the business cover its bills with what it has coming in? So if you think about it, you have cash. In current assets would be cash with accounts receivable. Accounts receivable, you're collecting. You're expecting that can you cover your liabilities that are going to come up in the next 12 months with the assets you have that you'll collect in the next 12 months. If that number is negative, what that's telling people is business isn't doing too well.

[00:04:09.470] - Dan Paulson

Exactly.

[00:04:10.050] - Rich Veltre

Because you're going to hit a problem in the next 12 months. When you're doing an acquisition and you're going to go buy a company, I've seen some of these very enthusiastic buyers come in and say, I love the company, I'm just going to buy it. Don't worry about networking capital. What?

[00:04:32.160] - Dan Paulson

It's pretty ballsy.

[00:04:35.720] - Rich Veltre

What's going to happen is the seller looks at it a little bit differently. The seller looks at it as there's cash in that bank account. That's money that I've earned. It's mine. He's not really thinking about the definition of current assets minus current liabilities to come up with networking capital. He's thinking that cash is mine or the receivables were already built. So when you collect those, that's mine. Because it's jobs that we already did. Exactly. To a certain extent, he's correct. Except the part that he forgets is the liability side, right?

[00:05:14.120] - Dan Paulson

That whole liability thing. I have actually had similar discussions with people I've worked with that have either been buying businesses or selling businesses. Another side of that whole working capital thing that some young or inexperienced sellers might not realize is that they also have to include what they're buying the business for. Because I tell them, you want the business to be self-sustaining. You don't want to sit here and buy something, then all right out of the gate, you got to start pumping money into it to cover the loan, because you talked about it, SBA loan or some other financing is usually going to be what it's going to take to get this buyout to go through. And if there's no working capital in the business and there's nothing to pay the loan and pay the bills, you now have doubled down on what your risk is going to be making this whole deal work. Right.

[00:06:06.940] - Rich Veltre

Totally agree with that because I have two examples right now, literally, where they're hitting, I'll call it the skids. They didn't pay attention to networking capital when they came in, so they made their offer. And the offer is all good. They did the whole analysis, EPDA times the multiple. What's the proper multiple? Negotiated it out the right way. But at the end of the day, they allowed the seller to say, Okay, well, I'll keep the cash and the receivables. And while your point about the loan is absolutely 100 % accurate, the thing that comes faster is you took over a business that if it had employees, they're going to want to get paid.

[00:06:49.110] - Dan Paulson

Paid, yes.

[00:06:51.250] - Rich Veltre

There has to be enough money in the bank to get you to the point where money is flowing from what you actually and be able to pay the employees for the fact that they did work already that earned you something. There's that, when does the cash flow actually start? And what do we have to leave in the business? Literally two companies that I'm looking to try to help doing the exact same thing, where they did not consider networking capital, they do not have enough money in the bank. One of them, acquisition cost was actually so high because they used legal professionals and everybody to do all that work. They didn't have enough money come out of the deal to cover those costs. The other one just didn't predict that the cash flow was going to be slow enough that they would not have enough to hit that payroll probably in the second or third week. Cash is short, and now they're scrambling because it wasn't in their plan. They didn't have a plan.

[00:07:56.700] - Dan Paulson

That seems to be the common factor here. I mean, I personally don't get it. I mean, you're making a very big investment and you're just assuming it's like turning on a light switch. You go in, you buy the business, you take over, and immediately it's kicking back money. And if you haven't done the research, you haven't done the due diligence, you're going to find out the hard way that that is probably not going to work that well. Right.

[00:08:22.870] - Rich Veltre

Yeah. And the only way that you can protect yourself, now I'm getting really technical on what I'm about to say. I had to think about it for a second. It gets really technical. But if you had really good margins and very low expenses, then you probably can go longer without worrying as much.

[00:08:45.060] - Dan Paulson

And those businesses are few and far between. Very few and very far between. Most businesses are probably operating on margins of 5-10%.

[00:08:51.830] - Rich Veltre

I had one that was operating at 50%. It was unbelievable to see. Everybody couldn't believe it. They thought that the reports were wrong. They thought somebody made a mistake, but the margins actually were at 50 %. There was so much money being put through the business that their cash flow projections didn't actually matter as much. I hate saying that because it's so important. But if you have those margins, there's less of a margin of error. You have a big cushion. Yes. You can get away a little longer. The funny part was I was with them for almost a year. By the end, they started saying, This is such a great deal. We're going to put in all kinds of additional facilities. Their CaPEx went up. They started putting a lot of capital out into doing more projects. All of a sudden, they wished they had that projection really, really finetuned because they said, How are we going to pay for all that construction? Yeah. That's one of the few and far between that has that ability to be cushioned enough that they can not really worry about it as much. But eventually, all businesses really have to have some degree of a plan in front of them that they can monitor and work themselves against?

[00:10:21.630] - Dan Paulson

Yeah, that's the trick. Any plan you create is speculation. The only advantage you have with buying a company is some of that speculation can be mitigated because they have past sales, they have their systems and processes in place, hopefully documented, and hopefully that after the sale, they're still going to be people there who understand what's going on. But you still have to look at all that stuff and say, what's going to be our next step? How are we going to move forward? And how much money are we going to need? That's the big question that even I on the operations side, go, as you point out, Rich, there's still employees that want to get paid. I have yet to find an employee that's willing to say, no, I'll forego a check for the next 2-3 months while you guys figure this stuff out and just pay me when you can type thing. Don't see that too often. But you've really got to understand what's the length of time that you're going to need to float the boat, if you will. And that's where that capital comes in really handy. I don't know about you, but I look for typically a minimum of three to four months, ideally.

[00:11:37.340] - Dan Paulson

I'm sure there are standards out there, but if you can get up to six months, that's beautiful. But that's rare, again, with some of the margins that we're talking about.

[00:11:46.220] - Rich Veltre

Well, I think that I'm not really thinking of a good standard right now. I would probably say now I would be looking for longer because things are I'll call them questionable out there. We talk about the R-word, the recession-word. Are we in one? Are we getting one? Is it going to affect me?

[00:12:09.210] - Dan Paulson

How about the I-word? The inflation-word and the fact that money is more expensive to buy now.

[00:12:15.590] - Rich Veltre

The inflation-word as well. Or add another I-word, the interest rate. You have those pieces that you're trying to figure out. I would say you probably want to look at what the standard was and maybe make it a little longer. I'm being the conservative guy that I am. But I would also tell you that I'm thinking of this mostly. I started off talking about it mostly on the premise of a transaction where you're going to buy or sell a company. But networking capital is a key factor in any bank loan. It's one of those things the bank wants to know that your networking capital is running a certain way. So if you're looking at your own company, I would probably look back and say, calculate my networking capital over trailing 12-month period. What has the business shown me that it needs? Because your networking capital might actually be dropping. Because if those bank loans are based on flexible interest rates, they're going up. So your NWC, your networking capital is going potentially down. And then you really want to look at your business that way. And then I would tell you, if you're doing an acquisition, looking at a target, I would do the same thing.

[00:13:35.050] - Rich Veltre

Watch the trailing 12-month period, figure out your net working capital and figure out if you've got enough cash to be able to keep operating the way you are, or if you're going to have a point where you can see that there's a need for you to make a change.

[00:13:50.410] - Dan Paulson

That's a good point. And I really agree with you that you need to keep that net working capital in front of you at all times. I think the only time people actually pull that out of their pocket is every couple of years the bank calls you up and says, hey, we need your last year's financials or we need your last couple of year's financials. And that's typically the only time most people worry about it. I don't know of too many companies or too many business owners that keep a close eye on that networking capital throughout the course of a year.

[00:14:22.680] - Rich Veltre

Yeah. And to add to that, it almost seems like still I ask for financials and somebody hands me or a forward looking forecast or budget, and I'm like, where is the rest of them? Balance sheet and cash flow are important financial statements that people really should be looking at at the minimum. So if you're looking solely at your profit and loss statement, that doesn't translate to do I have enough cash? That only tells you you're still busy.

[00:14:52.960] - Dan Paulson

Right.

[00:14:54.560] - Rich Veltre

So these are the things I think, KPIs, which are key performance indicators. Network and capital is one of them. Depending on your industry, you probably have a few others, but they are not ones that you just calculate now and then six months from now you say, Well, maybe I'll calculate it again. You really want to look at it on a trend because some of them will change and they'll give you a stark warning that something's going on and you want to be able to use those to make decisions for the company.

[00:15:28.180] - Dan Paulson

So is there a quick checklist that we can tell people that they should be looking at or what they should be doing? Because again, I might be making some assumptions here, but I'm willing to bet that there's a lot of business owners, especially in some small to medium size companies, that typically don't take a close look at this.

[00:15:48.450] - Rich Veltre

I can guarantee it. The vast majority of people that I've talked to, when I talk to an owner of a business, they can tell me their sales number, they can tell me their receivables are under control, they could tell me their cash number. But there's other things that would tell you whether or not there's a way to predict that something's not going the way you think it is. Two-second story before we get too far off the tangent. But I had 2007, we know that the banking crisis started and I had a client that was holding on to inventory and everything was totally normal. Nobody knew anything was going on. And then all of a sudden we did our monthly report. And in the monthly report, we did a KPI for them, which was actually called DIO, days inventory on hand.

[00:16:37.080] - Rich Veltre

And.

[00:16:37.990] - Rich Veltre

When we did that, we realized, wait a minute, that number is higher than it should be. And then we went back and double checked the numbers from previous reports and we realized it was climbing. The reason it was climbing was because in the banking crisis, all of the bigger companies that we sold chemicals to for their manufacturing process, they had readjusted all of their orders because they had that they were going to have a decrease in what they could sell. Surprise. Our DIO was climbing and we had to say, Wait a minute, guys, we have almost a year's worth of inventory and we have orders coming in. We are still going to be heading up towards that one, one and a half years worth of inventory on hand. The chemicals have a shelf life, so you can only sell them up to a certain point. We couldn't take any more of our own orders. We had to make our own adjustment. Had we not looked at that DIO, we may not have had that conversation until we were above and had to actually destroy some inventory because we wouldn't be able to sell it.

[00:17:41.890] - Dan Paulson

You also pointed out a good problem or a good example there, though, at least from the operations side. It shouldn't have just fallen on you at that point. There should have been somebody else in the company that should have seen that these orders were coming in or slowing down, and there should have been an alert put out. That's the example of where from an operations side, you need systems and process, and you also need to teach your people to think big picture, because a lot of people just look at what's in front of them, and they don't analyze what they're doing, they just push through the widgets. And here's a perfect example of where this could have probably been alerted to you maybe two or three months earlier that there was a change happening.

[00:18:24.500] - Rich Veltre

Yep. Yeah, absolutely. I think it highlights also, if you're working in a team setting, nobody brought this up until it came down to one person on the final report that was going to the parent company. That's when we saw the DIO. So the person doing the purchasing, I think, probably should have seen that. It should have been something that in a team meeting or a team setting, there would have been, Hey, I'm noticing something's going on. What do you guys think? It should have happened, didn't. But that's why we can talk about it today, though.

[00:19:02.180] - Dan Paulson

Well, I have a similar situation with a client of mine that there was actually, in this case, an error in their software that was kicking back essentially refunds to customers, and they weren't aware of it until it had snowballed enough to where their cash flow was pretty much nil. And they're still working on recovering from that. And then on top of it, trying to go back to the software company and get them to own up to the mistake that happened because it turns out it was a software glitch. And of course, the company goes, well, it's not our problem, that's your problem. So these are all the fun games you get to play when you're not watching that cash flow and keeping a close eye on it. And ultimately, at least in my books, there should be cash reserves and you should be building those and keeping those at all times.

[00:19:52.910] - Rich Veltre

Yeah. And I think the level of cash reserve brings us full circle back to what is your networking capital because you want to be able to keep that as your cash reserve at minimum.

[00:20:04.180] - Dan Paulson

Exactly.

[00:20:05.350] - Rich Veltre

Yeah. I think this highlights the fact, Dan, that we need to tell people, look, if you are thinking that you're not getting enough information and you need some help figuring out what it is you should be looking at, you should probably give us a call.

[00:20:24.050] - Dan Paulson

Well, definitely should, because this is not something your accountant is typically going to point out for you. And that's what people don't realize. There's tax accounting, there's bookkeeping, there's your general accounting where they produce the reports for you each month. But typically they're not doing the analysis. They're really not looking in-depth at what's happening in your company. They might look at a few key numbers and just say, Hey, this looks good, or that looks good. But I haven't really found any accountants that go out there and dig into the numbers deeply on your behalf, because typically they don't take the time to understand them. They just look and see what they got, and that's what they kick out.

[00:21:01.270] - Rich Veltre

Yeah. I think that these KPIs, they definitely are not calculating KPIs. Definitely, no. It's not a standard. And they basically expect that the people internal to the company are going to be doing that and not external. Plus, external is usually after the fact. They come in a month after the month over or a month after the year is over, and that's when they do their reporting. So I think there's a point where you may feel that you need to talk to somebody and take a look at are you analyzing your financials right? Are you getting your financials?

[00:21:40.550] - Dan Paulson

Now is the best time to do it because at the time of this recording, we are into the fall season. You're getting ready for next year. If you are doing strategic planning, you're starting to look at some of these numbers.

[00:21:53.520] - Dan Paulson

[00:21:53.840] - Dan Paulson

Make sure the numbers you're looking at are telling you the full story because what we find is they're not in most cases or you're not looking at the right numbers to tell you the right story. This is where it becomes so critical.

[00:22:08.300] - Rich Veltre

Absolutely. So Dan, if they want to talk to us and see if we can help them out and understand exactly what they should be looking at, how do they get a hold of you?

[00:22:18.200] - Dan Paulson

Well, they can get a hold of me at DanPaulsonlet'sgo.com. That's the easiest way to do it because my email address is way too long, so it's better to just fill out the form and reach out to me that way. Rich, how about you?

[00:22:31.070] - Rich Veltre

You can reach me by email at rveltre@veltregroup.com.

[00:22:35.090] - Dan Paulson

See, I need a shorter email address like that. That's just so much better. And if you want to catch other episodes here, we have, I think, we're over 20 episodes now. Can you believe that, Rich? We've been doing these weekly for the last 20 weeks. Crazy. But this is something that we've enjoyed working on and I think it's helpful. But you can go to booksnbiz, B-O-O-K-S, the letter N, B-I-Z. Com, and you'll get to see all the past episodes we've done. And we're getting shorter, more efficient. We're really hitting our stride on some of these topics here, so we love to hear from you. Please like, subscribe, and share. By all means, share. We love it when people share our topics here because we do believe they are helpful to a lot of business owners out there. Rich, anything else you got to add as a last takeaway?

[00:23:31.470] - Rich Veltre

Nope, I think that's it for me today.

[00:23:35.330] - Dan Paulson

All right. Get your books straight. That's the bottom line here. We will see you next week, Rich.

[00:23:41.700] - Rich Veltre

All right. Take care.

[00:23:43.720] - Rich Veltre

All right.