Learnings from a startup: Part 1 - finances
It's four and a half years now since I started an enterprise with a close friend and classmate, and it has been one rollercoaster ride all the while! I've been thinking a lot lately about what I've learnt from the experience, and decided to write down my thoughts in a series of intermittent blogs.
Today's topic - The importance of working capital
I'm writing from the perspective of running an unfunded services business in India (the laws and practices might be different in other countries). Requirement of working capital is obvious in a product-development environment but more insidious, and harder to justify, for us services guys. Let me build up the perfect storm pointwise:
1. Accrual accounting: I had no idea what this term meant before I started out. It means simply that the incomes and expenses for a time period are calculated based on the invoices issued during that period, and not the actual cash flows. So, in a year if I have done work and invoiced projects worth Rs 2 million, then my income for that year is Rs 2 million. Similarly, if I can produce employee payslips, phone bills and travel receipts dated within a time period, I can claim those as expenses. Let's say the sum total of the above is Rs 1.2 million. This system does not look at how many of the invoices and bills have been actually paid.
In a services business, it is fair to assume that all the accrued expenses would equal the cash expenses, being for things that demand to be paid on time or face the threat of eviction, disconnection or walkout. However, it is common that clients delay payment for quite large periods of time without penalty. Nobody complains too much if they are fined by the phone company for delayed bill payment, but try the same when you are a startup company servicing a large client and they cry foul and will likely not give you any more business. Thus, one has to grin and bear the receivables to build up long-term client relationships.
Assume the receivables for the year total Rs 1 million. This is not too farfetched, because in a growing company you would have more invoices issued toward the end of the year than the beginning, with a higher ratio of those remaining unpaid when the year ends.
2. Depreciation: Simply put, this is the percentage of an asset that is counted as an expense in a year to account for its loss of value. Let's say I buy computers worth Rs 300,000 during the year, cash down. Since purchasing a computer justs converts my assets from cash into computers, this in accounting is not counted as an expense. Instead, a percentage of the computer asset value (say Rs 100,000) is taken as an expense, to account for the fact that these computers would need to be replaced over time.
Let's see what we end up with:
Things get worse in a situation where the company is growing. If the cash policy does not change, the profits would increase, but so would the receivables, until it reaches a level that it overwhelms the shareholders, who realize their original plan of reinvesting profits back into the company to fund growth is not achievable. Thus growth suffers due to lack of available funds.
So what's the solution? A series of hard decisions:
Today's topic - The importance of working capital
I'm writing from the perspective of running an unfunded services business in India (the laws and practices might be different in other countries). Requirement of working capital is obvious in a product-development environment but more insidious, and harder to justify, for us services guys. Let me build up the perfect storm pointwise:
1. Accrual accounting: I had no idea what this term meant before I started out. It means simply that the incomes and expenses for a time period are calculated based on the invoices issued during that period, and not the actual cash flows. So, in a year if I have done work and invoiced projects worth Rs 2 million, then my income for that year is Rs 2 million. Similarly, if I can produce employee payslips, phone bills and travel receipts dated within a time period, I can claim those as expenses. Let's say the sum total of the above is Rs 1.2 million. This system does not look at how many of the invoices and bills have been actually paid.
In a services business, it is fair to assume that all the accrued expenses would equal the cash expenses, being for things that demand to be paid on time or face the threat of eviction, disconnection or walkout. However, it is common that clients delay payment for quite large periods of time without penalty. Nobody complains too much if they are fined by the phone company for delayed bill payment, but try the same when you are a startup company servicing a large client and they cry foul and will likely not give you any more business. Thus, one has to grin and bear the receivables to build up long-term client relationships.
Assume the receivables for the year total Rs 1 million. This is not too farfetched, because in a growing company you would have more invoices issued toward the end of the year than the beginning, with a higher ratio of those remaining unpaid when the year ends.
2. Depreciation: Simply put, this is the percentage of an asset that is counted as an expense in a year to account for its loss of value. Let's say I buy computers worth Rs 300,000 during the year, cash down. Since purchasing a computer justs converts my assets from cash into computers, this in accounting is not counted as an expense. Instead, a percentage of the computer asset value (say Rs 100,000) is taken as an expense, to account for the fact that these computers would need to be replaced over time.
Let's see what we end up with:
- Reported gross profit = Income - Expenses = 2 - 1.2 - 0.1 = Rs 700,000
- Tax to be paid on above = Rs 245,000 (say)
- Net profit = Rs 455,000
- Incoming cash = Rs 1 million
- Outgoing cash = 1.2 + 0.3 + 0.245 = Rs 1.745 million
- Shortfall = Rs 745,000
Things get worse in a situation where the company is growing. If the cash policy does not change, the profits would increase, but so would the receivables, until it reaches a level that it overwhelms the shareholders, who realize their original plan of reinvesting profits back into the company to fund growth is not achievable. Thus growth suffers due to lack of available funds.
So what's the solution? A series of hard decisions:
- Have better cash policies. Give incentives to clients for early payment and (perhaps) penalties for late payment.
- Recognize and book bad debts before the end of the year.
- Focus on improving cash flows, even if it results in lower growth. Give preference to those clients who pay promptly.
- Take on explicit debt. Too often, shareholders end up financing the shortfall by delaying their own salaries, leading to a loss of quality of life. Putting up money upfront as working capital while starting the business, and funding any shortfalls along the way through external debt while continuing to take regular salaries, might cost the company some money on interest but gives tremendous peace of mind and a feeling of fairness between shareholders.
great conclusion, shrik. there is no better way to get such learning than the hard way.
ReplyDelete-kakkar
Thanks, Kakkar! ...though for the sake of those aspiring entrepreneurs who're reading this blog, I hope you're not right :)
ReplyDeletesince theory goes against a part of your conclusion, if aspiring entrepreneurs were to just go on the basis of your blog, they might just learn the contrary the hard way. and that too would be great learning!
ReplyDelete--kakkar