Working capital is the term given to a company's available resources which it uses to fund the day-to-day activities. It is calculated as the current assets (stock, debtors and cash), less the current liabilities (trade and other payables) - basically the "middle bit" of the balance sheet.
The goal of working capital management is to manage the relationship between the current assets and liabilities so that the business has sufficient cash to pay its operating costs and settle short-term liabilities as they fall due; whilst maintaining efficient use of the assets.
Managing a business's working capital is important at all times, but perhaps even more so in the tough economic circumstances Scholes Chartered Accountants is currently seeing in many sectors. Generally we want the working capital to be a positive number, since a negative number (where short term liabilities exceed current assets) can imply that the business is unable to meet its short term financial obligations.
We are therefore concerned with managing all the different components of working capital, and the relationships between them:
You can use working capital ratios to benchmark how well your business manages its working capital; also to monitor trends that occur within your business over time. Monitoring these trends may give you an early warning signal that all is not going as planned, giving you time to take corrective action. Let's now look at the key ratios...
...by the way, if you want to follow along, why not pull out a copy of your actual profit & loss account and balance sheet - you could use the last annual ones, or a more recent set of management accounts, if you have those to hand.
Debtor days tell you the average amount of time it takes your customers to pay. The longer they take to pay, the more strain it places on your working capital.
The calculation is: (outstanding debtors / annual turnover x 365)
In theory debtor days should work out at or around your normal credit terms, so for example if you offer 30 days credit on all your sales, we might expect debtor days to average out at the same period. If debtor days significantly exceed your expected number, or if the trend is towards an increasing number, then this would warrant investigation. You could start by reviewing your aged debtors list to see if you can identify specific debtors that could be skewing the results, or whether there is a more widespread issue needing attention.
Creditor days tell you the average amount of time you take to pay suppliers. Taking longer to pay creditors can help your cashflow in the short term, but carries significant risk if your business consistently fails to keep within any agreed credit terms, since in the long run suppliers may offer less credit or even walk away.
The calculation is (outstanding creditors / annual operating costs* x 365)
*only include those costs that are invoiced by suppliers - ignore wages.
In theory creditor days should work out around the normal credit terms offered by your suppliers. If creditor days exceed your expected number, or if the trend is towards an increasing number, review your aged creditors list to try to pinpoint the underlying reasons. There could be a dispute or issue with a specific supplier, or perhaps you have negotiated extended terms with a supplier.
Stock days tells us how long your business takes to turn stocks into cash. It is a good measure of efficiency; generally a business should not hold more stock than is necessary to meet demand and manage any risk of short term disruptions in the supply chain. Overstocking is more likely to lead to wasteage or obsolescence, and ties up cash and resources that could otherwise be deployed more profitably elsewhere in the business.
The calculation is (stock at cost / annual cost of stock sold x 365)
A high or increasing number can point to issues with overstocking or slow moving stock, which in turn may strain working capital; where that is the case you may need to consider how to reduce stock levels, perhaps by organising a sale.
Current & quick ratios
These ratios express the relationship between current assets and current liabilities - the essence of working capital.
The current ratio is calculated as (current assets / current liabilities)
Normally we want a current ratio of at least 1:1, and ideally up to 2:1; any ratio below 1:1 can imply that the business has insufficient liquid resources to meet its short term obligations.
The quick ratio (also known as the acid test) takes this a stage further by excluding stock from the calculation, since it can be difficult to turn stock into cash quickly.
The quick ratio is therefore calculated as ((cash + debtors) / current liabilities)
Here, we are normally looking for a ratio in excess of 1:1.
The art of working capital management is in identifying and responding to potential liquidity problems before they arise. Tracking working capital ratios and trends in your business can help you do that.
If you'd like to discuss any of the issues covered in this article, contact us today.
Read more about our services.