Is it possible for a profitable, growing business to experience financial difficulties? Absolutely.
Let’s take a look at this fictional company: it has seen its revenues grow at a rate of over 30% in the last 2 years and predict to normalize for the third year while still showing a gross margin growth ranging from 15% to 20% and profits from 4% to 5% of its turnover. At first glance, everything seems perfect.
However, despite this sustained growth, the company is in financial difficulty. Its working capital is insufficient to support the rapid growth they have experienced in recent years. Although contracts are coming in from all sides and revenues are still rising, there are additional costs required to meet the demand.
On paper, revenues are higher than costs, which demonstrates the profitability of these contracts. The only problem is that these contracts are subject to a 45-day payment term while the company must pay its suppliers within 15 to 30 days for the underlying expenses. This gap between collections and disbursements creates an unbearable pressure on working capital. In other words, the funds go out faster than they come in. The company is therefore forced to max out its line of credit. And the more the company grows, the more serious the problem becomes.
The leaders make the decision to pump considerable sums to replenish the working capital – this saves them time, but the issue remains unresolved because the leaders excel at making their business grow. They are victims of their own success. The business continues to grow, and more costs must be incurred which worsens the working capital problem. Unable to inject additional funds and the bank refusing to raise the credit limit, the leaders are facing a wall.
What measures need to be taken to address the problem?
Given this impasse, it is clear that funds need to come in quicker. Given the company’s profitability, the company has resorted to factor certain accounts receivable to accelerate collections – at a discount. In doing so, its working capital stabilized and the pressure on it has eased.
What your advisor suggests
Contrary to what one might think, an increase in turnover is not always a guarantee of good financial health even if it is accompanied by a suitable gross margin. Unmanageable rapid growth is one of the first warning signs that any leader should be aware of. The use of debt such as loan on assets may in some cases help support growth when it has been well planned out and when the terms and conditions of financing have been analyzed properly.
Your business is growing, and you are not sure that your working capital is adequate to meet the demand? Do not hesitate to consult one of our advisors to determine the best solution for your company.