Working capital is vital to survival especially in this hard market. In this document, Chris Burand explains the importance of working capital.
What exactly is working capital? In essence, it’s a firm’s investment in its net current assets, or current assets minus current liabilities. Working capital is often measured in days. The formula is: (current assets-current liabilities)/(total annual expenses/365). Ideally, your agency should have 30 days or more. Less than that is often inadequate for survival when times turn tough.
We can compare working capital to a shock absorber. With adequate working capital, we can make it over the cash-flow bumps we hit on our roads to success. Eventually, every business will have a month, quarter, or year in which cash-out exceeds cash-in. Without a cushion, a business will go out of business — or at least face other unpleasant consequences, even if vendors, creditors, and employees know that the setback is temporary.
A single change in business practices can cause cash-flow bumps. An agency’s overall income might not change or might even increase in response to a change in practices, and its annual expenses might remain the same, or even decrease. But if the timing of cash flow changes, an agency without adequate resources could find itself desperate for that working capital.
For example: Suppose an agency decides to start billing clients when a policy is received, rather than at inception (a practice I don’t support). If an insurer demands its money within 30 days of inception but doesn’t deliver the policy until 60 days after inception, the agency must have 30 days worth of working capital to pay its companies. Without working capital on hand, how will it do that?
Or what happens when agencies move clients to E&S markets, which usually want their money earlier than standard markets. If an agency doesn’t change its billing practices to accommodate this, it must have working capital to cover the spread.
Or suppose an agency moves from agency bill to direct bill and continues to pay its producers fully upon renewal date. Since the agency is paying the producers up front but receiving its own commissions over many months, the cash outflow initially exceeds the inflow. Although the outflow and inflow even out over time, But many agencies run short and need money immediately. With adequate working capital, they could wait out the imbalance.
Historically, one way agencies have covered a shortage has been to collect enough premium early to pay their companies. Another word for premium used for this purpose is “float.” Float has allowed agencies to get by without working capital. It works wonderfully until an agency already extensively using float has a business interruption. Then it has no financial cushion. It’s estimated that 40% to 50% of all agencies are out of trust (which almost certainly means they have inadequate working capital).
Another reason an agency shouldn’t depend on float is that if it’s out of trust and using float to survive, it could be violating state laws (in some states). Even when an agency is in trust and using float, some people consider such a practice unethical because it amounts to robbing Peter (by collecting early) to pay Paul. Revenues are being banked and spent before they’re earned. If enough new business is coming in to cover what’s being lost, agencies can get away with this practice barring a business interruption.
Inadequate working capital decreases an agency’s value, often drastically. I was recently valuing a business (not an agency) that collected annual fees up front, totaling about $100,000. The business used this money to pay $80,000 in immediate bills. As a result, it had only $20,000 left with which to perform $100,000 worth of work (and its profit margin was not 80%!). How did they afford this? They sold more business and used the up-front fees to pay for other customers work. Does this remind you of a Ponzi scheme?
The owner said this was how they’d always done business and didn’t see a need for working capital. From a buyers’ perspective, however, this business had a $100,000 liability (a promise to perform certain work) and not enough capital to cover this work, unless they made another sale. To correct the problem, a buyer would have to invest $80,000 on top of the purchase price. Would a buyer pay top dollar knowing that they’d have to kick in another $80,000?
The same principle applies to insurance agencies that have inadequate working capital. No intelligent buyer will pay top dollar (or even an average price) for an agency knowing that it will need huge cash inflows to make it whole.
Agencies and companies get a lot of money up front that they don’t have to spend immediately, thus creating the magical float. For carriers, this cash might sit in reserve accounts for years before being used. This can mesmerize some executives into believing that they can do anything they want with it. Agents make a mistake by thinking that just because they have cash in the bank, including float, they have enough working capital.
Treat working capital like any other expense. Budget a certain percentage of revenues as an expense and deposit these funds in a bank account every year. Depending on an agency’s growth rate, most agencies should budget at least 1% to 3% of revenues as working capital. If an agency is working from a deficit, this amount obviously must increase.
Working capital is important for averting disaster, but it also enables an agency to take advantage of opportunities. Agencies occasionally get a chance to acquire another agency or producer at a great price. But doing so usually requires cash up front. An agency with enough working capital can grab these deals because so few other agencies will have enough cash to compete for them.
The risk of not having enough cash to pay bills increases dramatically without adequate working capital. On the other hand, great opportunities exist for adequately capitalized agencies because many inadequately capitalized agencies will fail. Why not have enough capital to take advantage of opportunities and make the road to success a smoother ride?
NOTE: None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.