Funding Your Business - 3 Equations for Deeper Business Insights

Welcome back friends! We’re shifting gears this month and diving into the different options available to help fund your business operations. We’ll be exploring traditional lines of credit, asset-based lending, factoring, SBA facilities, and other solutions over the coming months. However, I wanted to take this edition to help you establish a foundation to build upon.

Before you explore new funding solutions, you first need to have a firm understanding of how money is moving through your business. This is commonly referred to as your cash conversion cycle. Primarily, you’ll want to know how long money is staying in certain areas of your business. The three key areas we will focus on today are your Accounts Receivable Days on Hand, Accounts Payable Days on Hand, and Inventory Days on Hand.

I've also made a free Excel document available for you to use. This can be found here, with a snapshot below.

1. Accounts Receivable Days On Hand

Accounts receivable days on hand, or AR Days, is the measure of your company's ability to collect payments from customers for goods or services provided. This metric represents the average number of days it takes for a company to receive payment after invoicing a customer.

To calculate AR Days, you simply divide the accounts receivable balance by the total sales volume for the period, then multiply that number by the number of days in the period. The resulting figure represents the number of days that, on average, the company takes to collect its receivables.

For the purposes of my excel sheet, we just enter the data from your annual balance sheet and divide by 365. Keep in mind that if you want to look at quarterly trends, then you need to adjust the denominator to reflect the correct number of days.

Once we know the AR Days, then you can take things a step further and determine how much cash is generated every day from your accounts receivable. You do this by dividing your total AR by your AR Days. This number is helpful when you are exploring options to either shrink, or grow, your AR Days number. You can shrink this number by doing things like implementing new bill collection services, offering online payments, or renegotiating terms with your customers. Some of you may consider growing this number at certain times, the best example being you are considering adding a new client that demands longer payment terms than you currently offer. In this example, you are generating a “borrowing need”, something a line of credit could help with. More on this later!

2. Accounts Payable Days On Hand

Accounts payable days on hand, Days Payable Outstanding, or AP Days, is a measure of a company's ability to pay its outstanding bills to suppliers and vendors. This metric represents the average number of days it takes for a company to pay its bills after receiving an invoice.

To calculate AP Days, you simply divide the accounts payable balance by the cost of goods sold, then multiply by the number of days in the period. The resulting figure represents the number of days that, on average, the company takes to pay its bills.

Similar to the AR Days calculation, we just enter the data from your annual balance sheet and divide by 365. Again, keep in mind that if you want to look at quarterly trends, then you need to adjust the denominator to reflect the correct number of days.

Also, we can use the AP Days number to help determine the value of each day from your accounts payable following the same methodology discussed above.

3. Inventory Days On Hand

Inventory days on hand, or IDOH, is a measure of a company's ability to manage its inventory levels efficiently. This metric represents the average number of days it takes for a company to sell its entire inventory stock.

To calculate IDOH, you simply divide the inventory balance by the cost of goods sold, then multiply by the number of days in the period. The resulting figure represents the number of days that, on average, in which a company’s inventory is held on hand until it is sold.

Again, see notes from above to calculate the daily value of your inventory. All these calculations are completed for you automatically when using my free excel sheet, mentioned above and found here!

So what does this all mean?

The primary purpose of this exercise is to help you determine your borrowing needs. Banks will be looking at the same data, so you should have a leg up if you go into the application process with a solid understanding of your credit request.

To understand your historical borrowing needs, you first need to look at changes and trends over time. The excel sheet gives you the option to enter data from several years. From here, you’ll be able to see either growth or contraction in your AR Days, AP Days, and/or IDOH.

• For AR Days, growth is a USE of cash, contraction is a SOURCE of cash
• For AP Days, growth is a SOURCE of cash, contraction is a USE of cash.
• For IDOH, growth is a USE of cash, contraction is a SOURCE of cash.

This data can equip you with some initial knowledge when you are planning for which credit/line options will be best for your business going forward.

The key here is truly finding the right size line to meet your needs, as banks are very focused on issuing out exactly what they think you need to operate. To best understand this logic, you need to understand how a line of credit works from a bank’s point of view.

When a bank issues out a line, they are setting aside that money for you to use, similar to how they would for a traditional loan. The bank is pulling that money from their deposit base to fund these request.

However, the difference between a line and a loan is that there is nothing guaranteeing that the line will actually ever be used, or used to a certain amount.

The bank is paying interest on all their deposits, as a way to incentive people to keep their money there. If they set aside too much money into an unused, or underused, line of credit then they risk losing money on the deal. For example, lets say a bank issued out a $1,000,000 line of credit that isn’t used. They are earning 0% on that $1,000,000 while still having to payout a small percentage back to their depositors. The difference between the deposit rate the bank is paying and the interest they are getting from their loan/line products is called the “spread”, a term used in mostly all credit products.

Banks will often try to overcome this risk through various strategies like setting the line up on a sweep account that is automatically used, regularly reviewing the line on an annual basis, or assessing a fee if the line is unused.

A key note here, everything we have discussed so far has been focused on looking at the past. As you know, as a business owner, you are constantly looking forward into the future. You will also want to come well equipped with your forecast for growth and expansion. You can use your historical data to best gauge and estimate your future cash needs.

Which option is best?

Today’s newsletter was meant to help you establish a base of understanding around your businesses cash conversion cycle. From here, we’ll continue to explore various methods of funding your business, as well as methods for optimizing your cash flow.

Stay tuned as we dive into these topics over the coming months.?

And thank you all for your support. I truly appreciate your comments, likes, and shares!