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Does the fact a business requires a cash flow injection indicate that the enterprise is failing or struggling? Definitely not – any growing business will require increased buying power.
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Walking safely through the business "valley of death"
19 October 2015
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Many accountants will be familiar with one of the perils of high growth, often referred to as the "Death Valley Curve".
This ominous name highlights a common problem for start-ups and fast-growth enterprises, referencing the high probability that a fledgling business may fail before it secures a sustainable revenue stream, or that a business going gangbusters may not have the working capital to sustain the growth.
The challenge for high growth businesses, particularly those that sell on credit terms, is that they have a higher working capital requirement. They have increasing wage bills and supplier accounts as they need to hire more staff and buy more stock to meet demand, yet they often have to wait between 60 and 90 days to be paid.
Australian Bureau of Statistics figures indicate that only half of the businesses that started operating in 2010-11 were still operating by June 2014. Even allowing for business retirees, this statistic starkly indicates the risks facing every new business.
What can accountants do to make sure their clients are survivors?
Many things, but I'd like to focus here on cashflow - no matter what industry a business is in, one of the key success drivers is effective cash flow management.
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Options for funding rapid growth
The "Death Valley Curve" occurs when high growth businesses that may be very profitable on paper run out of cash as the profits are tied up in stock and debtors, leaving them without the cash required to meet wages and other obligations as and when they fall due.
In this situation, despite being profitable the businesses is technically insolvent unless it can turn those current assets into cash.
As businesses experience rapid growth they are constantly looking to add more staff, services or stock to keep up with demand and this investment requires additional funding.
There are a number of funding options:
• Seeking new equity from outside investors. While this option can improve cashflow and expand the level of expertise within the business, it also dilutes ownership which often founders and entrepreneurs are loathe to do.
• Negotiating extended terms with trade creditors. This can buy breathing space but the downside is that it may have consequences such as increased prices or the withdrawal of discounts.
• An increase in the bank overdraft facility. This is a common option, however many business owners think twice about having to provide the real estate security usually required. There is also the issue of business performance covenants attached to approval of the facility, and the inconvenience of renegotiating the overdraft as the business grows. Essentially if a business is experiencing rapid growth but has a hard credit limit because the overdraft is secured against real estate, as soon as that limit is reached and the banks are unable to increase it because they are maxed out on loan to value, the business is running out of cash. All that has really happened is the business has outgrown the facility - something that doesn't happen with debtor finance.
• A debtor finance facility. This can be a winning solution for high growth businesses that sell to other businesses on credit terms. With the finance available being linked to the invoices raised, the faster the growth the more cash becomes available to meet those increasing obligations.
• Import Finance. This allows for goods to be paid for on shipment, with the facility being repaid in up to 90 days - giving time to turn the goods into cash, or debtors to be used for a debtor finance facility. The latter provides up to 180 days credit from shipment to when the customer pays.
How debtor finance (invoice finance) works
Debtor finance facilities are flexible and grow in line with turnover, so there is no requirement to continually renegotiate the limit. The business is basically receiving an advance on money it is already owed.
Usually you'll find no requirement for real estate security, so the family home can be made available to support personal borrowing requirements rather than put on the line for the business.
It is basically like an overdraft, with a limit set at about 80% of what invoices are outstanding, but without having to give bricks and mortar security.
To illustrate how debtor finance helps with growth, here's the simple example of a coffee machine importer who wholesales to other businesses.
Our importer buys a coffee machine for $100 and sells it for $250, but has to wait to get paid (possibly 45 to 60 days) before they can buy and sell another coffee machine.
With debtor finance, our importer would get around $200 against the invoice within 24 hours (with the balance on full payment by the debtor), meaning they can immediately go and buy two more coffee machines for their $200 and sell them for $500.
Now they will receive $400 against the second invoice and can buy four more coffee machines. And so it goes - a way to fund growth that doesn't rely on offering costly settlement discounts, but improves buying power and allows for negotiation of discounts from suppliers for early payment.
Food for thought - and a great way for any growing business to walk confidently through the "Valley of Death".
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