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Bootstrap invoice for Finance

welcome back to our series on bootstrap financing 101. today's video we're talking all about working capital what is it why does it matter what is the cash conversion cycle how do I determine the working capital requirements in my business answers to these questions and More in our episode today my name is Tony Wilson certified public accountant Certified Management accountant and I'm the owner and proprietor of equip fractional CFO Services where we help software development agency owners like you build the businesses they love without going bankrupt in the process as always this video is meant for educational purposes and should not be construed or considered as investment or legal advice always consult with the appropriate advisors before making any significant decisions in your business let's Dive In [Music] maybe you've heard this term before but what exactly is working capital working capital is the lifeblood of your business in one sense definitionally it's the difference between your current assets and your current liabilities let's say I have a hundred thousand dollars in the bank some prepaid airfare of five thousand dollars and some outstanding bills of twenty five thousand dollars as of this point in time we'd say you have working capital of eighty thousand dollars but when I'm speaking with bootstrap software companies and software development agencies I'm usually referring to working capital in the sense of how much money should your business have in the bank to handle the normal ebb and flow of cash balance throughout the cash conversion cycle now don't worry we're going to talk about what the cash conversion cycle is later in the video in a lot of ways working capital is kind of like body fat you don't always eat food right before your body needs to use the energy I mean you sleep don't you instead your body stores excess energy in the form of fat then when you your body needs to use it the fat stores will be broken down much in the same way working capital gives your business a healthy buffer so it can maintain operations without going bankrupt when you inevitably pay your largest operational expenses like payroll so we know what working capital is why does it matter aside from making sure your business is profitable ensuring your business stays liquid is the most crucial aspect of running your software development agency especially if you want to avoid being bankrupt working capital just so happens to be the mechanism we use to stay liquid making it possible to meet all of our short-term obligations are you working with a freelance WordPress developer to help on one of your clients projects they're going to want you to pay their invoice on time or they may think twice about working with you in the future or how about all those purchases you've been making on your credit card you could make a late payment or not at all but the consequences for that decision are going to cost you a lot of money maintaining an appropriate amount of working capital will help you meet those obligations without delay but just like body fat too much working capital actually is a bad thing you might not think of it this way but cash which goes undeployed in your business will incur unwanted opportunity costs let's say you determine seventy thousand dollars is the optimal working capital for your business but you're averaging a hundred and twenty five thousand dollars you've affected close yourself off from deploying that fifty five thousand dollars elsewhere in your business could you have taken that fifty five thousand dollars and built your own micro SAS product that could return 15 to 20 on your investment or maybe you could take thirty six thousand dollars of that and run a 12 month experiment with that video marketing agency you've been eyeing for a while you're not going to know if video content works for your Dev agency unless you try it and if you land two forty five thousand dollar projects because of the video work that could be a 25 return on your investment the point is having a properly funded working capital balance is crucial but you also need to avoid over funding your working capital because you may be missing out on some important Investments now do you remember earlier in this video when I said the cash conversion cycle did that have you scratching your head or perhaps immediately Googling the term let me explain it traditionally the cash conversion cycle is defined as the time it takes for your business to convert raw materials into cash through sales it typically comprises three key phases inventory story accounts payable and accounts receivable as a software development agency you don't have inventory that you're converting into a final product instead as a service based business you really only have accounts receivable and accounts payable let's say you close a deal on April 1st it's one month long and you agreed not to bill the client until the application launches at the end of the month April 30th they agree to pay the invoice within 15 days of receiving the invoice May 15th but you have contract developers working on this project fortunately they've agreed to be paid in one lump sum but they expect that payment on the last day of the month April 30th from the day the client signed until the day the client paid their invoice was 45 days was that the cash conversion cycle fortunately not even though the client paid 45 days after the contract began you also benefited from paying your contract developers 30 days after their contract began the cash conversion cycle in this instance was only 15 days said differently you would be on the hook to finance 15 days worth of operations out of your own pocket to keep the business running that 15 days is where we start when considering your working capital requirements if you want to know how much working capital your software development agency needs you must consider two major aspects Current financial metrics and plans for future growth The Current financial metrics that I look to most often for my clients are Day sales outstanding days payable outstanding and trailing 12 months of total expenses with just these three I can get pretty close to a recommendation for the working capital levels my clients need let me show you how I do that like we talked about before your cash conversion cycle is effectively Day sales outstanding minus days payable outstanding so if I average 30 days sales outstanding and 10 days payable outstanding a cash conversion cycle is 20 days I know that my client should be ready to finance 20 days working capital in their business but how does that translate to a dollar amount take your trailing 12 months of total expenses and divide them by 365. maybe total expenses for the trailing 12 months was 1.2 million dollars for your business which translates to 3288 on a daily basis now if you need to finance 20 days of operations that comes out to 65 760 but we're not done yet if you're like any Dev agency owner I've met you're planning to continue to grow your business so this is where you need to stop and consider what that growth looks like for you as a shorthand you can use a simple growth rate say 10 to tack on top of your trailing 12 months of total expenses where you had 1.2 million in trailing 12 months at a 10 growth rate that's 1.32 million into the future which translates to a daily rate of three thousand six hundred sixteen dollars and when you multiply that by 20 days of operations and you're looking at seventy two thousand three hundred and twenty dollars now it's important to note with recommending working capital Targets this is both an art and a science yes we use calculations like the one I walk you through to figure out a good ballpark but we also consider some subjective factors like the specific days when payroll comes out or one-off projects that might temporarily increase your cash conversion cycle from 20 days to 28 days typically fractional CFOs can be your partner in establishing these targets but with some simple back of the napkin math you can come up with a halfway decent Target of your own and there you have it an insightful look into working capital and its role in your bootstrapped business from defining working capital and understanding its significance exploring the cash conversion cycle to determining your specific working capital requirements these concepts are fundamental to effective financial management if you found this video informative please consider giving it a thumbs up subscribe to our channel for more enlightening content and hit that notification Bell until next time [Music] thank you