Working well with working capital helps practices succeed

Working well with working capital helps practices succeed

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Apr 01, 2007

To many veterinarians, working capital is simply the cash they have on hand to pay their bills. Others may understand that it also includes such assets as accounts receivable and inventory.

Unfortunately, however, few principals in veterinary practices fully understand working capital — how important it is for their business, how it is measured and how to obtain it.

By strict definition, working capital is simply the amount by which the veterinary practice's current assets exceed its liabilities. Too little of it means that the practice soon will be unable to pay its bills. Too much means that someone is passing up the opportunity to make business improvements or at least wise investments.

Working capital spells liquidity

Liquidity exists when a veterinary practice can satisfy its maturing short-term debt. It is especially important in times of adversity, such as when a practice is shut down by a natural disaster or when losses result from local economic conditions or a significant downturn in referrals. If liquidity is inadequate to cushion such losses, serious financial problems may ensue.

Poor liquidity might be likened to a fever – symptomatic of a deeper, fundamental problem.

The liquidity of a veterinary practice is particularly important to creditors, representing a safety cushion. If a practice has a poor liquidity position, it may be a poor credit risk, unable to make timely interest and principal payments. Therefore, measuring the liquidity of the practice is essential when analyzing its working-capital requirements now and in the future.

Working capital is measured using this simple formula:

Working capital = Current assets - Current liabilities

For example, suppose Dr. Joe's veterinary practice shows assets (cash, accounts receivable, inventory, etc.) for the current year of $120,000. Subtract current liabilities of $55,400, and it leaves him with $64,600 in working capital.

If that represents even a slight increase over the previous accounting period, it's a positive sign for the practice's health and positioning to meet future needs.

Measuring working capital

If a veterinarian applies the simple formula (current assets minus liabilities) to determine his or her working capital but looks no further, little will be accomplished toward determining the practice's future working-capital needs and how to meet them. Thus, the need for a working-capital analysis.

One useful analytical tool for many veterinarians is the so-called "operating cycle," a way of measuring accounts receivable, inventory and accounts payable in terms of days.

Under that system, accounts receivable are analyzed by the average number of days it takes to collect them.

Inventory of such things as supplies and resale products is analyzed by the average number of days it takes to turn over the items (from the point it comes in the door to the point it is converted into cash or an account receivable).

Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice.

Many practices cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable alone. This shortfall typically is covered by net profits generated internally or by externally borrowed funds – or a combination of the two.

It is no secret that retailers sometimes must find working capital to fund seasonal inventory buildups between September and November for Christmas sales. Likewise, many veterinary practices require short-term working capital at certain times.

Funding

There are several potential short-term funding sources, but first it's important to plan ahead. To be caught off-guard may mean missing a great opportunity – or scrambling to fund payroll and other essential expenses.

Here are five of the most common sources of short-term working capital:

  • Equity. Many veterinarians must rely on equity funds for short-term capital needs. These might come from personal resources, a family member, friend or third-party.
  • Trade Credit. A practice that enjoys a particularly good relationship with its creditors – perhaps by regularly paying its bills on time over an extended period — might be able to negotiate extended terms to work through a slow period.
  • Factoring. Once a bill has been sent, a factoring company buys the accounts receivable, then handles the collection. This is more expensive than conventional bank financing but, handled discreetly, has proven an effective source of working-capital financing for many practitioners.
  • Line of credit. Lines of credit are given to well-capitalized, well-run practices and businesses that show promise. A line of credit allows the veterinarian to borrow funds for short-term needs as they arise. The funds are repaid once the veterinarian collects the accounts receivable. Lines of credit typically are made for one year and are expected to be repaid in 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only.
  • Short-term loans. Not every practice can qualify for a line of credit from a bank, but some might be able to get a one-time, short-term loan (less than a year) to cover temporary working-capital needs. A DVM with a good banking relationship might use the loan to cover on-order, seasonal-needs or accounts-receivable buildup.

Finding out about your working capital

Every veterinary practice's financial standing can be summarized by using three key accounting statements from its bookkeeper, accountant or computerized bookkeeping system: the balance sheet, the income statement and the statement of changes in financial position.

The balance sheet might be described as a photograph of assets, liabilities and owner's equity in the practice at a given time. The income statement is like a motion picture, showing profitability over a period of time such as a quarter or a year.

By subtracting expenses from income, the income statement reveals the amount of profit (or loss) for that accounting period. The statement of changes in financial position explains the fluctuations that occur from one accounting period to the next, focusing on the sources and uses of funds.

The term "statement of changes in financial position" is of recent origin. Formerly called the income statement or balance sheet, it is required of nearly all publicly-traded companies.

Since 1970, the Securities and Exchange Commission has required this statement as part of the annual registration information for all companies listed on organized stock exchanges. It also must be included as part of the accounting information for firms whose financial statements are audited by public accounting firms. Veterinary practices increasingly are discovering its value.

As the term implies, the statement of changes in financial position explains the fiscal changes that occur in a business or practice from one period to the next. It is sometimes referred to as the "where got, where gone" statement because it discloses financing and inventory activities between operating periods.

The statement looks at working capital to determine a practice's ability to meet its expenses and remain operational in the period ahead.

Working capital thus represents cash flow — the name of the game for all successful business ventures.

Mr. Battersby is a financial consultant in Ardmore, Pa.