Why working capital will grow
If you are a growing business, you will be experiencing increasing demands to fund higher levels of working capital. Some businesses have a higher working capital burden than others. For example, manufacturers may carry high levels of inventory as well as high levels of receivables. Service companies will generally have a lower level of working capital, but it is still a funding issue.
The ceefo Wealth Engine program forecasts working capital growth over a 5-year outlook period. Our clients are always surprised at how much additional capital will be required to fund this growth.
As an example, one client with current working capital of $9.9m and forecast revenue growth of only 5% per year for the next 5 years, will see an increase in working capital of $more than $2.5m. Under a more aggressive revenue growth strategy of 8.5% per year over the same period, that client will need to fund $4.7m of additional working capital.
How will you fund the growth of working capital?
Working capital is funded in much the same way as other assets in the business. The funds will either come from retained earnings or they will come from a working capital funding product such as invoice financing.
To understand what funding source to use, the business needs to have a funding plan for the outlook period. That funding plan must incorporate all the investment needs of the business. These fall mainly into the following categories:
- Capital investment in fixed assets or other capital items (e.g., security deposits)
- Capacity maintenance (depreciation represents the amount that needs to be invested to maintain the productive capacity of the business)
- Working capital growth
- Debt principal reduction commitments
Under our 5-year planning model you will understand the forecast retained earnings & forecast capacity maintenance amounts that are available to fund all capital demands. You will also understand the capital requirements of the strategic investments in the business along with the working capital demands and debt principal reduction requirements. Once you have all this information, you will fully understand what level of additional funding you will need.
What impact does working capital have on your ability to achieve a high return on equity
Apart from the need to fund the growing working capital demands of the business, increasing working capital is a brake on achieving target return on equity levels. Working capital is more a cost of doing business in that it does not generate a return on investment.
To provide an illustration of this brake on returns, let me provide two examples of growth.
Scenario 1 – 10% increase in revenues to drive the increase in profitability
- Under this scenario, working capital is likely to grow by around 10% as well
- The funds needed to fund this increase cannot be used for investment in other productive assets
- The investment in productive assets will need to achieve higher returns to offset the additional funds applied to working capital
Scenario 2 – Profitability is increased from investing in automation which reduces cost of sales
- There is no increase in working capital and therefore no additional funds are required
- These funds are applied to productive assets and the return on investment will not need to be as high as in scenario 1
So, working capital does have a significant impact on capex returns and available investment funds.
How the Wealth Engine program provides more context to the growth in working capital
The ceefo Wealth Engine program is specifically designed to address these issues and quantify the strategic planning impacts on capital investment budgets and required return on investment over the outlook period.
One of the most powerful impacts of the Wealth Engine program is that it enables proactive strategy driven capital investment planning rather than the reactive needs driven capital planning that all too common in the SME sector.
Ask your CFO or advisor to implement the “ceefo Wealth Engine Program” and support you to establish and maintain your own WEALTH ENGINE.
