Do you really understand working capital?

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Never starve your business of working capital, buy what you can easily afford.

 

Fail to understand working capital your peril

Operational efficiencies and better working capital management will drive profitability, facilitate growth and reduce risk while improving sustainability. Working capital improvements provide a genuine way to overcome your cash flow strain and sleepless nights.

Lack of cash is the major reason why we need investors. You might have plenty of assets and don’t see working capital as important. Many are confused by the difference between assets and working capital. Working capital is an asset, but an asset isn’t necessarily working capital. Tracking the numbers is essential if you are to attract good investors and ensure financial viability.

Working capital is used as a key indicator of the health of a business and its capacity to pay its bills as they fall due. Potential investors take a hard look at your Working Capital Ratio as a way to evaluate how much of your assets are liquid and how much are not. Working capital is the money you use to run the business and pay your bills.

 

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety”. Benjamin Graham

 

If the bigger the percentage of your assets are working capital the more liquid your company is and the better you can respond to changing business conditions and have the peace of mind knowing you can pay your bills on time, every time.

Investors often check out your working capital to determine whether you can survive short and longer-term slumps in sales or revenue.  Many lenders will require businesses to meet a minimum working capital standard in order to qualify for loans and maintain a capacity to meet loan repayments during the lifetime of the loan.

There are substantial trade-offs between cash flow management, customer service, costs and risks. In order to optimise your overall working capital management performance, you will need to recognise and understand these tradeoffs so as to implement a continuous improvement program that takes them into account. It will require a holistic approach across the various functions of the business, including customer and supplier value drivers.

 

How to determine your working capital

Businesses with negative working capital may lack the funds necessary for growth and reinvestment. In some cases, negative working capital may be an indicator of a more serious problem. It is almost always advisable to build cash within your organisation.

Financial business planning and tracking key indicators such as your working capital should be a part of the management plan, which is reviewed and analysed in a timely fashion.

Working capital is used to fund business operations and purchase inventory. These operations and inventory are then converted into sales revenue for the business.

Working capital = current assets – current liabilities.

 

How to determine your working capital ratio

Working capital ratio = Net working capital / Total assets

For example, if your total assets are $1,000,000.  This includes your building, your vehicles, your inventory, your cash, everything.  Your working capital totals $400,000. 400,000 / 1,000,000 = .4, so your Working Capital Ratio is 40%.

The working capital turnover ratio is one of the few financial analysis tools you can use to determine the relationship between funds used to support operations and the sales resulting from such operations. Failure to establish the relationship between these two accounting elements can be disadvantageous to the operational efficiency of your business. Knowing the benefits of a high working capital turnover ratio can help you use this tool more effectively.

A very high working capital turnover ratio can also show that a business does not have enough capital to support its plan for sales growth.

 

Working Capital Turnover

The working capital turnover ratio is also referred to as net sales to working capital. It indicates a company’s effectiveness in using its working capital. The working capital turnover ratio is calculated as follows. Working capital turnover = net annual sales divided by the average amount of working capital during the same 12 month period.

For example, if a company’s net sales for a recent year were $1,000,000 and its average amount of working capital during the year was $200,000, its working capital turnover ratio was 5 ($1,000,000 divided by $200,000). With this ratio, you can operate with a high degree of comfort. However, if your sales were $1,000,000 and the average working capital was only $80,000, the working capital would be 12.5, which means you would always be struggling to pay your bills and take advantage of payment discounts and other opportunities.

A measurement comparing working capital to the generation of sales over a given period provides some useful information as to how effectively a company is using its working capital to generate sales.

The working capital turnover ratio is used to analyse the relationship between the money used to fund operations and the sales generated from these operations. In one sense, the higher the working capital turnover, the better the utilisation of funds, because it means that the company is generating a lot of sales compared to the money it uses to fund the sales.

When used in the analysis of your business, the ratio can be compared to similar businesses, or to your own historical working capital turnover.

 

What is a liquidity ratio?

A liquidity ratio is an indicator of whether a business’s current assets will be sufficient to meet their obligations when they become due.

The liquidity ratios include the current ratio and the acid test or quick ratio. The current ratio and quick ratio are also referred to as solvency ratios. Working capital is an important indicator of liquidity or solvency, even though it is not technically a ratio.

Liquidity ratios sometimes include the accounts receivable turnover ratio and the inventory turnover ratio. These two ratios are also classified as activity ratios.

 

What is the quick ratio?

The quick ratio is a financial ratio used to gauge a business’s liquidity. The quick ratio is also known as the ‘acid test’ ratio.

The quick ratio compares the total amount of cash + marketable securities + accounts receivable to a number of current liabilities. The quick ratio differs from the current ratio in that some current assets are excluded from the quick ratio. The most significant current asset that is excluded is inventory. The reason is that inventory might not turn into cash quickly.

 

[read more=”Personal Experience” less=”Personal Experience”]

Personal Experience

Keeping your business financially sound requires that you pay close attention to the financial data you are generating every day. This means having sound bookkeeping and a good accounting system which will provide you with good control over you working capital

Each component of working capital has two dimensions, time and money. If you can acquire money to move faster around the cycle by collecting debtors more quickly or reduce the amount of money tied up in inventory relative to sales.

Or if you sell off obsolete or underutilised equipment, the business will generate more cash and won’t need to borrow as much money to provide for an optimum level of working capital.

You must generate enough income, in both profits and capital, to meet your operating expenses and service any debt, while allowing for additional working capital to fund the growth you are aspiring too.

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