Boosting Your Financial IQ
Boosting Your Financial IQ
133: Listen to This to Avoid Growing Yourself Out of Business
In this episode of Boosting Your Financial IQ, Steve Coughran discusses a critical yet often overlooked issue for fast-growing businesses—managing capital intensity. He explains how, even with profitability, a business can face bankruptcy if working capital and capital expenditures are mismanaged. Steve shares insights and practical calculations to help entrepreneurs avoid growing their businesses into financial trouble. Tune in to learn how understanding your capital requirements can keep you on the path to sustainable growth.
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And these two things can kill your business if you are not aware of them. This podcast, Boosting your Financial IQ, is about business, financial literacy, strategies for profitability and the principles taught at byfiqcom. My hope is that you will apply the lessons learned and that we can work together soon in my mastery program. Enjoy the show and don't forget to subscribe. Are you growing a profitable business, but you're wondering where the heck is the cash? In other words, are your bills piling up or are you tapping into your line of credit to make payroll? If so, this episode is for you, because I'm going to be talking about the number one killer of businesses, especially fast growing businesses.
Speaker 1:Now, I've worked with a lot of entrepreneurs. I've seen a lot of different companies across multiple industries of all different sizes, and here's a common issue that I see Now. Some entrepreneurs are like yes, let's grow the business, I'm excited to pour the gasoline on and drive more growth and hey, look, that could be a good ambition, but if you don't understand the capital intensity of your business, you can grow yourself out of business into bankruptcy, in fact. So let me explain here. So, when I talk about capital whether it's in my Financial Pro program, where I'm talking about invested capital and returns on invested capital and returns on invested capital, or when I just say capital generally, Typically what I'm referring to is the combination of two things.
Speaker 1:First, we have working capital, which is essentially the difference between current assets and current liabilities. Now there's a nuance here, because with your current assets, you're going to want to subtract out any excess cash. In other words, if you're sitting on a bunch of government incentive money, such as like ERP loans or PPP money, or you're just stacking cash in your business and you're not taking distributions or you're not reinvesting it, so any cash above and beyond normal operating requirements should be deducted from your current assets. And then you take current assets and you take the difference between that and current liabilities and on the current liability side, you're going to want to deduct out any interest bearing debt. Okay, so let me say that again when I'm talking about working capital, I'm referring to current assets less excess cash above and beyond normal operating requirements and current liabilities less interest-bearing debt. All right. So when you take the difference between these two items, you arrive at working capital.
Speaker 1:Now the other component of invested capital is going to be your net property, plant and equipment. So think about it. When your business invests in things like equipment, machinery, a building, whatever it may be in order to run normal operations, that's considered PP&E property, plant and equipment. And I say net because we want to account for accumulated depreciation. So remember, you buy a truck for $50,000, it lasts for five years and then it's going to go down to zero. Then you're going to depreciate it $10,000 a year for five years. In other words, you're going to take that $50,000 value of the truck and you're going to write off $10,000 each year for five years over its useful life. That's called depreciation. And then that depreciation that you're accounting for on the income statement every year accumulates on the balance sheet, right? So that's accumulated depreciation and net property, plant and equipment closely resembles your capital expenditures, right? So there are some nuances here, but I'm going to just keep things really simple, really high level here. But essentially what I'm talking about is the amount of cash you have to invest in machinery and equipment, in buildings and so on and so forth, all these assets in order to run normal operations, All right. So those are the two components that I'm referring to with invested capital, your working capital and your net property, plant and equipment. All right. Those two things combined together equals invested capital, and these two things can kill your business.
Speaker 1:If you are not aware of them, I was working with a company once and the CEO's like Steve, we are ready to go, we're ready to grow, we have a new sales and marketing machine in place and we are driving all these leads into our business. We're going to convert these leads and we're going to just take off like a rocket ship. And I was like, hold on, before you go down that path, let's analyze your strategy. And they were currently doing about $3 million a year and they had a plan to get to $12 million in just a couple of years. So I built out a model and I looked at things like their working capital as a percentage revenue and their capital expenditures as a percentage revenue, and I found that, based on their current capital structure in other words, how much equity in debt they had, if they were to grow their business according to their plan guess what? They were going to bankrupt the business right, which is crazy to think, because you're like Steve, how can I grow profitably and bankrupt my business If I'm making money? How can I go out of business? In other words, Well, remember, 70% of companies that go bankrupt are actually profitable when they close their doors because they ignore working capital and they ignore capital expenditures.
Speaker 1:Right, and that's really the net PP&E that I'm talking about. It's the accumulation generally, right, there are nuances there. I'm generally speaking about the accumulation of your capital expenditures, which show up as net property, plant and equipment on your balance sheet. All right. So you might be thinking, whoa, Steve, hold on there. I just wanted to tune in and listen to you talk about growing my business. I just wanted to tune in and listen to you talk about growing my business.
Speaker 1:The reason why I'm doing this episode is because it drives me crazy out there in the market, because there are marketing firms, right, that are like, okay, we could do this to your business, We'll enhance SEO, We'll do paid ads, We'll help you to create funnels, We'll strengthen your offer. We'll do all these things in order to drive more sales. But if you are not paying attention to the finance side of things, you can get yourself in a lot of trouble, and I see this over and over again and in fact, I fix a lot of companies that go down this path without a plan related to maximizing returns on their invested capital. All right, so let's take a step back and let me explain what capital intensity means for a business and how do you know if you have a high capital intensity business. Well, there's two things that you can do, two calculations. High capital intensity business Well, there's two things that you can do, two calculations.
Speaker 1:First, you can compute your working capital as a percentage of revenue. Now, when you do this, make sure you look at your annualized revenue. So if you're just looking at it today, for example, as of September, you're going to want to look at your trailing 12 months revenue. In other words, you're going to want to look at your revenue from October of last year through the end of September. If you're going to look at it on a trailing 12 month basis, or you could look at it from September through August, or January through December, whatever it may be you just want to look at your revenue on a 12 month basis, an annualized basis. In other words, don't take your working capital calculation and divide it by your monthly revenue, Otherwise it's going to be all over the place, All right. So trailing 12-month revenue is going to give you the most stable denominator, All right. So let me walk you through how to do this calculation Go to your balance sheet and, as of a certain date so let's just say we're doing it as of the end of September pull a balance sheet as of 9.30, right?
Speaker 1:Then you're going to look at your current assets and your current liabilities. Remember, you want to subtract out any excess cash. So if you're sitting on cash above and beyond normal operating requirements, you're going to want to subtract that out. Now you may be wondering all right, Steve, how do I figure out my operating cash requirements? Well, if you look at your income statement and you look at your operating expenses, your overhead, your selling, general and administrative expenses, in other words, the costs that are required to run the business I'm not talking about cost of goods sold, I'm just talking about your overhead cost. If you look at those costs and you average them out for, let's just say, three months, that could equal your operating cash. Right? If you're comfortable with three months of cash or 90 days of cash, Now, for some companies they may feel comfortable with an equivalent of three months of overhead in cash. Or maybe they feel more comfortable with six months or nine months, or whatever it may be. For every business it's different, but that's just one way you can figure out your operating cash requirements.
Speaker 1:All right, so you take your current assets, minus out any excess cash that you have above and beyond this amount, and then you take your current liabilities and you subtract out any interest-bearing debt. If you have credit cards and you're carrying a balance, you're paying interest on those credit cards, or you have a line of credit that's classified in current liabilities but you're paying interest on it, then you're going to want to subtract out those amounts. Now, if you're just using your line of credit and you are racking up a certain amount every month but you're paying that off, that could be included in the calculation. You just don't want to include any interest bearing debt, any debt that you're carrying a balance on for more than one month at a time. All right, so current assets minus excess cash, current liabilities, less interest bearing debt.
Speaker 1:Take the difference between the two. There's your working capital amount. Then take that amount, divide it by your annualized revenue, right, so that gives you your working capital as a percentage revenue. Now, if the number that you come up with working capital as a percentage revenue is above 20 to 25%, that means you likely have a high capital intensity business. Now you can do the same thing as it relates to capital expenditures. Now you can find capital expenditures on the statement of cash flows in the investing section. And if you do the same thing, take your CapEx, divide it by your annualized revenue. So do the same thing that we did with working capital and if you come up with a number that's greater than 10 to 15%, guess what that may mean that you have a high capital intensity business.
Speaker 1:So typically, if you're in telecommunications, manufacturing or industries like construction, typically you're going to require high levels of capital in order to operate your business. It doesn't mean it's a bad thing, it's just something to be aware of, because let's just say that working capital in your business is 20% as a percentage of revenue. So for every $1 million you grow in revenue, guess what You're going to need 20% of that for working capital. In other words, you grow by a million dollars in revenue, you're going to need $200,000 in working capital to cover your capital needs. Right, your capital requirements the difference between your accounts receivable, your inventory, your prepaids and your other current assets and your current liabilities, your accounts payable, your accruals, all these other things that rack up under current liabilities. You're going to need cash or capital set aside to cover these working capital requirements, because you're shelling out a bunch of cash to do the work, but then you have to wait to get paid and if you are not careful, this will put you out of business.
Speaker 1:Now, going back to the example of the company, that's like let's go, Steve, let's grow from three to $12 million. Think about that. I mean, that's $9 million in revenue growth. And let's just say that they had a working capital requirement of 20%, or maybe it's a combination of working capital and CapEx of 20%. Well, if they grew by $9 million, they would need $1.8 million in capital in order to cover these requirements. And guess what? If you can't secure a line of credit fast enough, or if you're not retaining enough profit in the business and you're not generating enough free cash flow, you grow by this amount and you go bankrupt.
Speaker 1:All right, so that's what I wanted to talk about today, and I wanted to share with you a few calculations that you could do in your business right now in order to understand your working capital requirements and your CapEx requirements, and knowing these two numbers is going to be super critical when it comes to running and growing your business Now, before I sign off, if you want to explore this topic even further. That's why I have the Financial Pro course. In this course, I dive deep into these concepts, and these concepts are super critical if you want to be successful at leading a business. All right, you can learn more about the Financial Pro course by going to byfiqcom. Or maybe you're just like Steve. I don't need to take a course. I just want to talk to you about my business and I want you to come in and help my company grow sustainably.
Speaker 1:You can hit me up at cultivarcom. That's my business, where I turn around and grow companies. You can go to the website. You can schedule a free call right now, no obligation, no pressure. If you just want to talk business, talk numbers, go there, set up a call and we can start a conversation. All right, that's all I have for you and until next episode, take care of yourself. Cheers.