Working Capital

Posted by PITHOCRATES - December 3rd, 2012

Economics 101

A Business Owner uses Start-Up Capital to Pay the Bills until the Business starts Making Money to Pay the Bills

Few people understand how business works.  Some think it’s a mystical entity that has an endless supply of money for the taking.  To be taken by the government.  The unions.  And their employees.  While some believe business is some evil entity that acquired its wealth by taking it from poor people.  Poor people that had no wealth to give.  Because they’re poor.  Who we define as being poor because they have no wealth.

But businesses aren’t mystical or evil.  They’re run by ordinary people.  Often doing extraordinary things.  In a constant battle to survive.  They start off by risking everything they’ve ever earned and saved.  Perhaps persuading family to invest in them and their idea.  Or mortgaging their house to the hilt.  Just to get the money to start their business.  Short term financing to pay the bills until the business starts making money to pay the bills.  If the business ever starts making money to pay the bills.

One of the most misunderstood things about business is that their prices are pure profit.  When you buy a $4.50 cup of coffee from Starbucks people think that’s $4.50 of profit.  But it’s not.  That price has to pay for the coffee beans.  The water.  The regular milk.  The low-fat milk.  The flavored syrup.  The cup.  The cup sleeve so you can hold it without burning you hand.  The lid.  The plastic stick that plugs the drinking hole in the lid.  The baristas working there.  The equipment to grind the coffee beans.  To make coffee.  To make espresso.  To make steam to heat the milk.  The point-of-sale cash registers.  The lights.  The heat.  The air conditioning.  The Internet access provided free to their customers.  The soap and toilet paper in the restrooms.  Garbage bags.  Cream.  Sugar.  Sugar substitute.  Coffee stirrers.  The rent.  The telephone bill.  Marketing.  Etc.  They have to recover all of these costs in the sales price of their coffee.  With enough left over to pay for growth.

For a Business to be able to Pay their Bills their Current Assets must be Greater than their Current Liabilities

Bills.  Everyone has them.  And business owners have more than most.  Because it takes money to make money.  A business owner has to spend a lot of money to make something to sell.  Like a cup of coffee.  So they incur a lot of costs.  Costs that their revenues have to pay.  For a business like Starbucks that’s mostly cash and credit card sales.  For other businesses that could be sales on account.  Or accounts receivable.  Sales that don’t result in cash.  But a promise to pay cash later.  Like a lot of those bills Starbucks has to pay.  Things they bought on account.  With the promise to pay cash later.

Businesses have current liabilities.  Which include the bills they owe.  Accrued payroll.  Accrued payroll taxes.  And everything else that they have to pay within one year.  All of which they have to pay with current assets.  Such as cash.  Or short-term assets they can convert into cash within one year.  Like accounts receivable.  Or things that conserve cash.  Like prepaid expenses.  For a business to be able to pay their bills their current assets must be greater than their current liabilities.  If their current liabilities are greater than their current assets, though, they will have some problems paying their bills.

The relationship between current assets and current liabilities is important.  If we divide current assets by current liabilities we get the current ratio.  If this is greater than one then a business will find it easier to pay their bills.  If it’s less than one then a business will struggle to pay their bills.  And may not be able to pay their bills.  If they can’t they are insolvent.  Meaning that they are not selling at high enough prices.  They’re not selling enough.  Or their costs are just too great at the prevailing market prices.  And if any of the above is true they may have no choice but to file for bankruptcy protection.  Because they simply cannot pay their bills.

If a Business can’t Generate Cash (Working Capital) Borrowing Money will only Delay the Inevitable—Bankruptcy

Cash is king.  A business has to have it.  And if they’re business can’t generate it they have to get it someplace else.  Either by borrowing it from the bank.  From family.  Or taking out another mortgage on their home.  All of which are short-term solutions to a much bigger problem.  For if their business can’t generate cash borrowing money will only delay the inevitable.  Bankruptcy.  Which means they either have to raise their sales volume.  Raise their prices.  Or cut their costs.  To get their current ratio above one.  Making them solvent again.

When you subtract current liabilities from current assets you get a business’ working capital.  The greater a business’ working capital is the easier it is for them to pay their bills.  And the easier it is to grow their business.  Or to offer raises, bonuses, more generous benefits, etc.  For to do any of these things a business first has to be able to pay their bills.  If they can keep paying their bills and maintain a current ratio above one for a few consecutive accounting periods they will find themselves with a surplus of cash.  Or working capital.  Useable cash to expand business operations.  Or to better pay their employees.

Of course if a business is too generous with their employees it will dry up that working capital and make it harder to pay their other bills.  For example, when generous union contracts impose heavy costs on a business while the prevailing market prices prevents them from charging enough to be able to afford those generous union contracts a business will soon find itself in financial difficulties.  Leading to a possible bankruptcy.  Where a bankruptcy court allows them to renegotiate their union contracts.  So their sales at prevailing market prices can afford them.  As well as their other bills.  While leaving enough working capital left over to grow their business.  Replace some worn out equipment.  Or repay a loan.

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