It sure is not intuitive.
Here we must do a little math calculation together to make a point. Even if your business collects a full year’s revenue up front, you are still going to get hit with this.
Here’s the math and a wake-up call:
Assume that your gross margin from sales is 50% for ease in calculation. Assume 30 days to collect receivables from completed work, and 30 days to complete the work. Finally, assume a fixed overhead equal to all the remaining 50% of revenues, just for the sake of making this point. Zero profit.
Let’s turn on the growth of revenues:
Consider an increase in your revenues from one million a month to one and a half million, the extra five hundred thousand to be billed in 30 days upon completion of work. During the first 30 days, you pay out over that period seven hundred-fifty thousand, the fixed overhead and cost of sales. That’s two hundred-fifty thousand more than last month, putting you in the hole. You bill the one and a half million on the thirtieth day and start the clock, waiting thirty days for receipt of the cash. During that time, you receive the one million you billed the month before but pay out another seven hundred-fifty thousand in overhead for the following month.
The declining slope of cash available
[Email readers, continue here…] Where do you sit the moment before collecting the one and a half million billed last month? You are down an extra five hundred thousand beyond the breakeven amount back when you were billing a steady one million a month and paying out 50% for cost of sales and 50% for pre-ramp overhead. It took your company finding or funding two hundred-fifty thousand a month for two months to finance an increase of five hundred thousand in revenues.
Surprise? Most managers are.
If the growth continues, the amounts needed just increase and increase, until finally fixed overhead is no longer such a large part of revenues (growing more slowly than revenues), and perhaps margins increase with buying power and efficiencies of mass production.
Can’t you just use more bank credit?
With an asset-based bank line and a limit far higher than current need, a company can borrow against those receivables and eliminate at least the second two hundred-fifty thousand of cash needs, since the receivable “pledged” for the bank line increases by five hundred thousand. Most companies have little headroom in their asset-based bank lines, and such expansion of revenues can be accommodated only for a while before the line is borrowed to its maximum.
Growth requires its own unique form of working capital cash planning. The mere fact of rapid growth is not enough to create capital within most organizations until the growth becomes more stable and receivables collections catch up with costs advanced to “buy” that growth.
Images created with DALL-E3 using prompt: “A female entrepreneur at her business desk with a computer showing her company’s bank balance and with a puzzled look on her face. Realistic images.”
