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Working Capital and the Role it Plays in Your Business’ Success

3 min read

Working Capital, what is Working CapitalThe accounting term working capital is essential knowledge for all business owners. Basically, it is the ability of a business to meet its ongoing obligations. Learning about some of the different aspects of working capital is vital for any successful business owner.

Net operating working capital (NOWC) is the gap between a business’ current assets (accounts receivable, inventories, cash, though excluding marketable securities) and its non-interest-bearing liabilities (which are financial obligations a business must meet, except those not subject to interest payments).

This calculation looks at a business’ cash flow availability and determines available current assets able to be liquidated inside a calendar year.

The formula is as follows:

NOWC = Current Assets – Non-Interest-Bearing Liabilities

Operating Working Capital (OWC)

OWC measures a business’ current assets and calculates how much the company’s day-to-day operations cost. This includes meeting supplier invoices, turning accounts receivable (AR) into cash, obtaining inventory, and making sales on inventory and/or services.

The higher the OWC, the easier it is for a business to pay supplier invoices, leverage pre-pay or early pay discounts, maintain healthy inventory stocks, and offer customers favorable terms to grow sales further.

OWC is calculated as follows:

OWC = Current Assets – Non-Operating Current Assets

It’s important to remember that cash isn’t included because this asset is considered a non-operating asset. While cash isn’t immediately connected to operations, it can be re-considered an operating asset once supplies and related items are obtained with it.

Operating Working Capital Considerations

The OWC calculation determines how proficient the business is with its finances. Since it immediately reveals the amount of funds a business has, the larger the resulting figure, the lower the funds a company has available to complete its rotation.

Companies can lower their results by increasing the rate of inventory turnover, increasing the percentage of customer payment collection, and working with vendors for better provider terms. As a business improves this metric, it can free up funds to reduce its loans, pay dividends, and/or build out new or existing revenue streams. 

Net Working Capital (NWC)

Also referred to as working capital, NWC is defined as the difference between total current assets held by a business and its liabilities. It shows a business’ level of liquidity. This looks at how capable a company is in generating profits, chiefly when it comes to near-term financial obligations (paying wages, electric bills, leases, etc.). It also tells a business if and how much it’s able to re-invest to grow profits and increase product or service capabilities.

It’s calculated as follows:

NWC = Total Current Assets – Total Current Liabilities

Total Current Assets = Cash Assets + AR + Inventory  

Current liabilities are short-term financial obligations due within 12 months, including accounts payable (AP) and accrued expenses.

Considerations

Positive net working capital implies a business can meet current financial obligations and invest in other operational needs. If the NWC is too high, the business isn’t using its short-term assets efficiently. Since some current assets can’t be converted to cash easily, NWC isn’t always the best measure of liquidity. It can similarly signify underused resources.

While there are unique considerations for every business, the more business owners and management are versed in these concepts, the more likely they are to increase their chances of surviving and thriving.

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Reduce Your Taxes by Putting the Right Assets in Your IRA

5 min read

Reduce Your Taxes by Putting the Right Assets in Your IRAMost people know the basic concept that certain types of investment accounts are tax sheltered while others are not. Think 401(k), 403(b), IRA and Roth IRA accounts, for example. What most people are not aware of is how you split your investment positions between your taxable and non-taxable accounts can result in major tax savings.

Asset Allocation and Location

One of the core principles of investing is to have an appropriate asset allocation that aligns with your risk tolerance and goals. In other words, how much of your investable net worth is in cash, stocks, bonds, precious metals, real estate, alternative assets, private investments, etc? Once you have this determined, the next consideration should be the location of these assets, primarily meaning whether you hold them in a taxable or tax-sheltered account.

The first, core principle behind asset location positioning is that bonds and other fixed income investments get the highest priority within tax sheltered accounts because they pay high-taxed ordinary income. Stocks that pay qualified dividends may be taxed at the more advantageous long-term capital gains rate, so they are typically better in taxable accounts.

What Are the Stakes?

To put it simply, big money. Take the example of a hypothetical $2 million portfolio evenly split between stocks and bonds. In the case where an investor has $1 million each in a taxable account (50/50 stock and bonds) and another $1 million in a tax-sheltered account (again 50/50 stock and bonds); this would cost about $148,000 over 30 years versus placing all the stock in a taxable account and all the bonds in a tax-sheltered account.

Asset Class Location Ranking

Of course, there are many more nuances and types of investments. Below we review 10 different types of assets, ranking them in order of those that get the most benefit from being in a tax-sheltered account with an explanation of why.

  1. K-1-Free Commodity Funds
    Popular for investing in futures, these are typically structured as Cayman Islands holding companies. As a result, they often kick-off highly taxed ordinary income even when the fund is losing money. Keep these in a tax-sheltered account at all costs.
  2. Junk Bonds
    High-yield corporate bonds typically come with large coupons (often 7 percent to 9 percent) and a small capital loss in the 1 percent to 2 percent range. Since the large coupon payment is taxed as ordinary income, while capital losses are worth less from a tax perspective, junk bonds are a prime candidate to go into a tax-sheltered account.
  3. Income Stocks
    Preferred shares and real estate investment trusts are characterized by their high unqualified dividends, so they are not eligible for preferential capital gains tax rates. This makes them best suited for a tax-sheltered account.
  4. High-Grade Bonds
    Similar to junk bonds, but with lower coupons and smaller capital losses, the benefits of holding these in a tax-sheltered account is less than the items above, but it is still preferable to place them in a tax-sheltered account.
  5. U.S. Treasuries
    The interest on U.S. Treasuries is taxed as ordinary income; however, it is exempt from state income tax. Depending on the state in which you are subject to taxes, these fall in the middle ground and could be held in either a taxable or tax-sheltered account.
  6. Actively Managed Mutual Funds
    The frequent churn of the holdings in actively managed funds typically creates more short-term capital gains versus long-term. Again, depending on total returns and how active the fund manager is, these could be held in either a taxable or tax-sheltered account.
  7. K-1 Commodity Funds
    Usually taxed as partnerships, profits typically get a 60/40 treatment, with 60 percent of gains classified as long-term and qualifying for favorable rates, putting them in the middle ground as well.
  8. High-Dividend Stocks
    For some investors, dividends are king. Think utility stocks and big-name blue chips with a steady track record of paying consistent dividends, like Altria. Since most, if not all, the dividend income is usually in the form of qualified dividends, holding these in a taxable account is much less painful.
  9. Stock Index Funds and Low Dividend Stocks
    Broader market mutual funds and ETFs have lower dividends. For example, on average, a total U.S. market ETF yields approximately 0.3 percent. Given this and their low churn, these funds are prime to be held in a taxable account, especially if the intended holding period is more than a year and will qualify you for long-term capital gains treatment and defer any taxable event until sale.
  10. Master Limited Partnerships (MLPs) and Private Real Estate Funds
    Typical of oil and natural gas pipeline investments, MLPs pay big dividends early on and they usually are not taxed in early years. Similarly, private placement real estate fund investments are shielded from the income they produce due to the upfront benefits of depreciation. Given their structure and the fact that they hold debt attributable to the owner, however, makes them a no-go for a tax-sheltered account since they create what is considered “unrelated business taxable income.” This makes these investments only suitable for a regular taxable account.

Conclusion

The decision of which types of investments you keep in either taxable or tax-sheltered accounts can make a big difference in how your investments grow and how much you keep. Consider evaluating not only your asset allocation but also your asset location to optimize for taxes.

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Defining Burn Rate, Gross Burn and Net Burn

3 min read

What is Burn Rate, Defining Burn Rate, Gross Burn and Net BurnWhen it comes to any business, but especially for a start-up, it’s essential to determine how long a company can survive before it must declare bankruptcy and/or close its doors. The biggest metric, especially for a start-up, is to determine how much money a company has to keep its lights on.

The term “burn rate” is defined as how much money a company spends monthly to maintain its operations. It is essential for a company to know how long it can operate before it begins to generate income and hopefully becomes cash flow positive.

It is important to look at two differences between the two sub-meanings of this term: the first is “gross burn” and the other is “net burn.” When it comes to “gross burn,” we are talking about how much a business uses in monthly operating costs. The following formula shows a business how long they have in months to operate.

For example, if a business has $2.5 million available for overhead and it spends $200,000 in monthly overhead costs, it would last 12.5 months. Expressed as a formula:

Available financial resources ($2,500,000)/monthly overhead($200,000) = 12.5 (months)

This assumes the company makes no revenue, which will be accounted for in the next example. However, this is where “net burn” comes into consideration. Net burn looks at how much money a business loses every month, but the difference with this calculation is that it looks at if it can be lowered by any incoming revenue.

If a company spends $10,000 on rent/office space, $20,000 on IT expenses, and $25,000 on employee wages, the gross burn rate would be: $55,000. However, if the company is generating sales at $17,500 per month, for example, and the cost of goods sold (COGS) is $5,000, the following calculation would determine its “net burn rate:”

Net Burn Rate = [Monthly Revenue – Cost of Goods Sold (COGS)] – Gross Burn Rate

Net Burn Rate = ($17,500 – $5,000) – $55,000

Net Burn Rate = (12,500) – 55,000 = -$42,500 Gross Burn Rate

The difference between the net burn rate and the gross burn rate may seem obvious or intuitive, but depending on how much money the start-up has available, and factoring in how much the revenue brings in and offsets the COGS, it can make a stark difference for the business’ prospects.

Once a business has determined what its “gross burn rate” and/or “net burn rate” is, the next step is to look at how to reduce costs and/or increase revenue to keep working toward positive cash flow. 

Two considerations for the company include what the business can do and what it must do to make more revenue and increase profit margins. For example, companies could look at the cost-benefit analysis of incorporating AI to see if it would have an overall positive impact on labor costs. They also could look at how to create effective marketing campaigns that cost less (using backlinks instead of paid search engine marketing, for example).

Another consideration is that if the company has enough time and is able to re-strategize its model, this can have a material impact on the business receiving a cash injection from outside investors.  

Determining these timeframes and figures are one way a company can reduce costs and/or pivot to more profitable products and/or services. These two calculations can provide avenues to re-invigorate a business in hopes of providing a path to profitability.