The rainy-day fund

In order to be sustainable in the long run, businesses must prepare for difficult times by saving during good times or just when excess revenues are available. It is essential to build working capital, or liquidity, during profitable times. This will carry the business through the inevitable periods of low returns or even losses.

In the current climate, companies that have not carried enough liquidity are finding themselves turning to lenders or selling assets to generate cash for everyday use. As many businesses worldwide are now discovering to their cost, this is not the best market in which to be trying to divest assets, or indeed to be raising urgently required finance.

In an average operating year, the owner manager needs to cover operating costs, service debt, make tax payments and extract sufficient income for his or her own living needs. In general, excess earnings then tend to go into further investment, capital replacement, paying down of debt, pension provision, and often, in the good times, to augment personal wealth. The other option, though, shouldn’t be neglected – building up the company’s working capital. As times get tough and you’re faced with reduced revenues, you’ll need that working capital to meet your operating costs, service debt and provide your income.

“It’s important to have an element of headroom for that event, which just might happen,” says Ernst & Young’s Sinéad Munnelly, partner in the transaction advisory group. “It’s important to take the sensible approach and not over-commit. At the moment companies are only going ahead with critical expansion, and they need to look at using their cash better. You’ll see that those companies that are expanding today are very strong and have a lot of cash reserves.”

“Prudent cash management becomes really critical in a downturn, but it also presents opportunities to challenge old ways of doing things, to take advantage of loyal customers and suppliers and to plan for the changed marketplace that will emerge,” says Denis O’Connor, partner at PricewaterhouseCoopers.

“Effective management will help ensure your business is best placed to come through the bad times re-energised and fit for the future. In so doing, businesses can reposition strongly for the upturn that will emerge,” he says, ringing an optimistic note.

So, how much working capital does a company need? “There is no rule of thumb. It depends on your business and circumstance,” says Stewart Dunne, partner for BDO Simpson Xavier’s business assurance and advisory services. “What is important is that management has accurate and reliable up-to-date information to base decisions on, and is constantly monitoring and reviewing its working-capital requirements and looking at forecasts and budgets.”

“Getting the overall capital balance between long-term and short-term funding is key,” says Conor Fennelly of Galway city-based accounting practice Duggan & Power. “Too often I have seen businesses fail not because they did not have the potential to be profitable, but because their capital structures were wrong, with too much short-term pressure on cash flows.”  

If you want to boost working capital, says Dunne, the old rule applies – work on maximising revenues by truly understanding your customers’ current needs,  and reduce costs. “The current economic climate doesn’t mean keeping your head down. There is still potential for growth, albeit small.” 

As regards cutting costs, Munnelly says there are benefits to these hardened times, and the current climate can be used to a company’s advantage. “At a time like this costs are actually easier to cut because suddenly everything is negotiable. The old rules are gone. People are open to talking.”

If your company has managed to boost working capital, it will need to put it within easy reach. In most cases companies will want to invest surplus working capital in products that will allow fairly quick access to funds if the need arises. Any such investments should be assessed on the basis of risk, yield and liquidity. Short-term business deposits or savings don’t tend to come with very attractive interest rates, but may guarantee the sustainability of your business in tough times, so they remain a popular route.

“Many will simply invest in simple savings or deposit accounts, but it should be noted that such income is taxed at 25pc, not the 12.5pc corporation tax rate,” says Fennelly. “That said, there are products available which allow for a form of portfolio investment in deposits. Effectively, investors’ funds are pooled together to invest in these deposits, thereby possibly availing of a better rate of return. Some of these funds are set up so that there is weekly liquidity available within the fund.”

Such funds can also be tax efficient for Irish companies that are deemed to be close for taxation purposes. The majority of Irish resident and owner-managed companies are deemed to be ‘close’ companies, that is to say they are ‘controlled by five or fewer participators or controlled by any number of participators who are directors’. Such companies pay a tax surcharge if they do not distribute investment and rental income. With portfolio forms of investment, the returns accumulate within the fund, and gains are only taxed on encashment.

Overall, building working capital is about managing the short-term financial health of your company, and not finding yourself firefighting. That rainy days come along is well demonstrated by current events. It makes sound business sense to plan to have a reserve on which your business can call when they do.