WORKING CAPITAL MANAGEMENT
Net Balance Position (NBP). NBP tells us how much cash a company has to finance its growth apart from normal operation. Empirical testing of the concept of NBP has demonstrated that it is a vastly more effective indicator of the company’s liquidity situation than traditional liquidity ratios. In fact, it has been shown to be one of the most powerful indicators of a company’s financial success or failure.
Building on this idea, we have developed a methodology that can be followed to free up cash reserves inside a business, mainly from non-cash current assets and accounts payable, to finance growth. Among others, the methodology focuses on changing a company’s business processes (for instance in purchasing to reduce the capital tied up in inventory).
Our team at HCS Business Solutions together with its network of partners offers comprehensive support for analyzing and reducing your company’s working capital to improve NBP and prepare for growth. To learn more about our approach and how we can assist you, please contact us at HCS Business Solutions.
Net Balance Position - Developed by Dr. Robert W. Pricer – a retired professor from the University of Madison School of Business, founder of the Wienert Center for Entrepreneurship, and one of the past directors of the SBDC in Wisconsin. Net Balance Position is a very reliable measure of working capital, Net Balance Position Analysis: Managing for Cash Liquidity
As most business managers know, the survival and success of a company is more dependent on cash flow than profit. Payment for wages, suppliers and other expenses must come from cash, which is generated from working capital. Managers commonly complain that their company’s have to borrow money to pay corporate income taxes – even though the firm is making a substantial profit.
Why do so many businesses continually have difficulty paying immediate obligations when they know the importance of adequate cash flow and working-capital management? In many cases the answer is that they rely too heavily on traditional measures of cash flow, which focuses exclusively on the Income or Profit and Loss Statement.
Such approaches typically determine cash flow by adding depreciation and amortization (non-cash expenses) to net income. However, that traditional method will only work during periods of constant sales, and is misleading during times of growth or decline (such as a recession). In fact, such a measure can lead to inappropriate and misleading decisions.
The technique, has been developed to allow business managers to more accurately predict cash flow and working capital generated by a business or business unit. This technique combines information from both the Income Statement (Profit and Loss) and Balance Sheet, along with planned or anticipated financial decisions, to accurately predict cash flow and working capital during periods of fluctuating sales. This approach is simple – avoiding “paralysis-by-analysis” – and can be easily applied to any business.
On a monthly, quarterly or annual basis, cash flow and working capital balances can be projected by completing the following process:
| Step 1: | ||
| From your current balance sheet: | ||
| Owner’s Equity (net) | $__________ | |
| Plus Interest Bearing Debt | $__________ | |
| Equals Permanent Capital | $__________ | |
| Less Fixed & Other Assets (net) | $__________ | |
| Equals Working Capital Available | $__________ | |
| Estimate Working Capital Needs: | ||
| Minimum Cash Required | $__________ | |
| Plus Accounts Receivable | $__________ | |
| Plus Inventory | $__________ | |
| Less Accounts Payable | $__________ | |
| Equals Working Capital Required | $__________ | |
| Working Capital Available | $__________ | |
| Less Working Capital Required | $__________ | |
| Equals Net Balance Position (Cash Liquidity) | $__________ |
Because the Income Statement (Profit and Loss) closes into the Balance Sheet, a good estimate of liquidity can be made using the preceding figures. Owner’s (Shareholder’s) Equity and Interest-Bearing Debt represent capital investment in a company. Part of this investment is used for Fixed and Other Assets and the remaining investment is available to be used for Working Capital.
A company must maintain a minimum cash balance and invest in accounts receivable and inventory average balances. Part of the required investment in these items will be financed by suppliers, and this is why Accounts Payable are subtracted from working capital needed. When Working Capital Required is subtracted from Working Capital Available, the company’s cash liquidity is determined. The cash liquidity is called the Net Balance Position (NBP) and this represents the base on which cash flow estimates should be calculated.
You can project cash flow and working capital liquidity on a monthly, quarterly or yearly basis, depending on your management needs, using the following procedure:
| Step 2: | ||
| Projected from current Income Statement (Profit and Loss) and Balance Sheet |
||
| Projected Sales (net) | $__________ | |
| Plus Other Income (net) | $__________ | |
| Less Accounts Receivable Change | $__________ | |
| Plus Accounts Payable Change | $__________ | |
| Equals Cash Inflow | $__________ | |
| Projected Cost of Goods Sold | $__________ | |
| Less Depreciation | $__________ | |
| Plus General and Administrative Expenses | $__________ | |
| Plus Selling Expenses | $__________ | |
| Plus Change in Inventory | $__________ | |
| Plus Change in Prepaid Expenses | $__________ | |
| Plus Change in Accrued Expenses | $__________ | |
| Plus Taxes | $__________ | |
| Equals Cash Outflow | $__________ | |
| Cash Inflow (above) | $ __________ | |
| Less Cash Outflow (above) | $__________ | |
| Equals Operating Cash Flow | $__________ | |
| Interest Expense | $__________ | |
| Plus Debt Repayment | $__________ | |
| Equals Non-Operating Cash Outflow | $__________ | |
| Capital Expenditure | $__________ | |
| R&D Expenditure | $__________ | |
| Dividend Distribution | $__________ | |
| Equals Investment Outflow | $__________ | |
| New Debt | $__________ | |
| New Equity | $__________ | |
| Equals Financial Inflows | $__________ | |
| Operating Cash Flow (above) | $__________ | |
| Less Non-Operating Cash Outflow(above) | $__________ | |
| Less Investment Outflows (above) | $__________ | |
| Plus Financial Inflow (above) | $__________ | |
| Equals Changes in Working Capital(above) | $__________ | |
| Add Beginning NBP (Step 1) | $__________ | |
| Equals New NBP (End of Period Liquidity) | $__________ | |
When companies are growing, or are in highly cyclical businesses, cash flow and working capital projections are not accurate since they don’t take into consideration the additional cash needed for increasing Accounts Receivable and Inventory Financing.
Also, growth requires additional investment outflow at some time and this places additional stress on working capital. When sales decline, most firms also erode working capital because they fail to react quickly enough, and costs soar in relation to actual sales.
The NBP technique should help you watch general cash expense categories as a percent of revenue if your business is being negatively affected by a period of decline.
If you are only looking at your net income or traditional measures of cash flow, you may think you have sufficient working capital when you do not. You must learn to understand and use new ways to accurately forecast your working capital position.
