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Business finance – the science of time and money
The equivalence of time and money is an anecdote referred to regularly but its truth rings true again and again as though it is a fundamental law of nature. The metaphysical truth of the statement can be demonstrated through the economic principal of Gamblers Paradox. We’ll discuss what that has to do with business finance shortly.
Gamblers Paradox teaches us something that the casinos know well, given enough time and enough money you will always find yourself in a position of profit. The casinos have more money and more time than any of its customers, so it is always destined to win.
Just for fun – here’s how it works
In Gamblers Paradox we are challenged to consider an even odds situation such as a coin toss. If the fall of the coin is guessed correctly the gambler will double his money, if it is not he will lose his money.
On the first toss the gambler selects heads and bets $1. There is a 50% chance this bet is correct but the toss lands on tails and the gambler loses $1. Unable to leave the game down the gambler doubles his bet and chooses heads again. The $2 bet will win him $4, which on his total investment of $3 (The $1 original bet plus the doubling down of $2) will yield a profit of $1, the profit he would have won if his original bet was guessed true.
The gambler doubles his bet because he knows that the chances of getting 2 tails in a row is 50% multiplied by 50% or 25%. The chances of a head on the 2nd toss is therefore 1 minus the chance of getting a tail or 75%.
If this bet also fails the gambler can double his bet again hypothetically doubling his chances of a win and winning his original bet back.
So what does this have to do with business finance?
Having ascertained that profit is determined through a factor of time and money, commercial finance is a tool that the profit seeker can use to maximise his returns.
The profit seeker sets up his business with the capital that he has in hand and needs capital assets (ie plant, equipment and vehicles) to make a monthly profit. Provided the monthly profit that his capital assets produce exceeds the monthly cost of capital (ie the interest on his borrowings and repayments) the profit seeker is in business.
Commercial Finance, the funding of capital equipment, is a simple model understood by most. People are unlikely to set up a business model where the monthly cost of capital will exceed the estimated monthly profit of the capital.
Things tend to come apart however when it comes to the real life blood of a business however, working capital.
Working capital is the daily cash that a business requires to be able to meet its obligations. There is only one reason that a business ever fails and that will be because it runs out of cash. This is a situation where the business has insufficient working capital to meet its daily funding needs.
Working capital can used to smooth the mis-match of timing between cost of commercial capital and the return on commercial capital.
A vehicle for instance may have a useful life of 10 years but the commercial finance provider may require payment of the vehicle over 5 years. Unless the return on investment of that vehicle is such that each month it will produce enough cash to make the initial 5 years of payments the business will need to fund this shortfall through its working capital.
To squeeze the most cash the business can out of its working capital it will need to reduce its debtors days and stock turn to as much as it can while pushing creditors out for as long as it can. This will generate a cash surplus in the initial years to cover the businesses cost of capital while the repayments are high.
Working capital funding
The value of working capital is calculated as current assets less current liabilities. When those current assets include a large debtors ledger, then the concept of positive working capital alone still doesn’t pay the bills, because it is not cash in the bank. Realistically the business will only be able to reduce its stock turn and debtors days so much and it may require working capital funding to make the numbers work.
This funding could be achieved through a business overdraft or through factoring its debtors.
Factoring allows a business to convert its debtors into cash, thereby providing the funding to allow the business to trade make a return on its capital assets. While factoring is often referred to as short-term funding this is not correct. It is actually daily funding that a business requires to achieve its long term business objectives, a return on its fixed capital assets. And it may involve a medium to long term relationship with the finance company.
The bottom line
Be it tossing a coin or running a business, the science of time and money is something that business owners must know to achieve profit. Working capital funding such as factoring or invoice finance, provides cash NOW – the ultimate timeframe for getting paid and securing business success.