Rule of 40 & Trade Capital

Trade Capital is an extremely important forecasting metric for a bootstrapped company. We learned this concept through our work with Brandon Gray and the Simple Numbers team, and it has made bootstrapping finance much easier for us to conceptualize and execute confidently. Why is this number so important? This number is going to tell you:

• If you can self-fund growth through bootstrapping
• How fast you can grow
• The approach you need to take to grow—i.e. Can you grow at a continuous rate? Or do you need to save, then grow, then save, then grow?

In essence, Trade Capital is the decisive number that reveals whether your business can thrive on bootstrapping alone or if you need to seek outside funding. Though the concept may seem complex, we will break it down.

How to Calculate Trade Capital

To calculate Trade Capital, you need to find out the net of your current assets and liabilities; you will find these numbers in your balance sheet:

• Figure out the number of your assets: your Accounts Receivable, your inventory, and your work in progress. This is all the money you have coming in.
• Figure out the number of your liabilities—i.e. the amount you're responsible to pay out. This might include Accounts Payable, accrued expenses, and deferred revenue.

Let's start with that, using small, easy numbers.

To figure out your Trade Capital Dollars, put those numbers together:

Beautiful! Now, let's get some context for this number. Take your Trade Capital Dollar amount and compare it to the dollar amount of revenue over the past twelve months. Use those two numbers to get a percentage:

Boom! You've got your Trade Capital percentage. Now, let's make that number useful for confident forecasting.

In order to forecast, you need to compare the Trade Capital percentage with your Profit Margin percentage (aka your Net Income percentage). Ideally, your Profit Margin percentage will be bigger than your Trade Capital percentage; when that's the case, you have cash coming in faster than you are spending it, which means you can continue to bootstrap your growth.

Let's figure out our Profit Margin percentage:

Now, you have all the numbers you need to strategically forecast with the Trade Capital measurement. The rule is this: If your profit margin percentage is higher than your trade capital percentage, then you can continue to bootstrap your growth without any additional capital infusion from external sources; that's very good news! That means you're in what Greg calls a Free Growth Zone. When you are able to forecast your trade capital, you are also confidently able to forecast your ability to self-fund, which is the peace of mind all entrepreneurs need!

What does it mean if your profit margin is lower than your trade capital percentage? Well, that's not great news. That means you're burning cash to grow and will be limited in your growth by how much cash you have on hand and how much debt you can draw upon. Maybe your profit margin is too low, and your liabilities are too high, and your terms are too long. You're giving customers ninety days to pay you. When you put all those numbers together, you're going to end up with a high trade capital percentage that may exceed your net income percentage. In that case—you're going to run out of cash at some point if you keep growing without pausing growth to build up cash reserves. You don't have enough money to pay employees to do new business, because it takes so long for you to get paid.

That doesn't necessarily mean you need to take external capital—you could take out a bank loan instead. You could even continue to bootstrap and fund your own growth, just at a slower rate. You'd want to use a "stair step" approach: save up, then fund growth; save up more cash, then fund more growth.

A Real-World Example

Here's a real-world example. Let's say you run a company that builds residential homes. You need to put down a lot of money to buy the property and materials and pay for labor—that's a great big number in your Liabilities column. But once the home is built and sold, you get a hefty paycheck: add that to your Assets column.

Now—do you need to grow your business slowly, building one house at a time? Do you need to get paid for the house you built before starting the next project? That's a slow model of growth. Do you have to keep taking out bank loans or investor money to fund your growth? That's no longer a self-funding model.

Or, you might find that your system works so efficiently, you're able to build and sell houses faster than the bills come due. You're in the Free Growth Zone! You're able to sell the homes so fast, you can use the profits to start your next project over and over again. You can bootstrap forever!

The Trade Capital percentage can be a challenging number to wrap your head around, but once you do, you'll be amazed at the assurance it gives you in bootstrapping your growth. Trade Capital can help you predict your cash flow from operations, helping you make confident strategic decisions.