Managing Your Company's Working Capital.
Net Working Capital = Current Assets - Current Liabilities
Current assets are assets a company converts to cash in 12 months or less. Most current assets for a company include cash and equivalents, accounts receivable and inventory. Current liabilities represent the liabilities a company must pay in the next 12 months. Examples of current liabilities include principal and interest payments due to creditors/banks and accounts payable due to vendors/suppliers. Working capital measures the company's ability to convert current assets to cash to satisfy obligations to creditors and/or suppliers.
For example, a company reports on its balance sheet current assets of $10 in cash, $20 in accounts receivable and $50 in inventory. On the liability side, the company reports current liabilities of $20 due to banks and $20 due to suppliers (accounts payable). Current assets total $80 and current liabilities total $40, Therefore, this company's working capital position is $80 minus $40, which equals $40 in working capital.
Working Capital Strategy
The cost of working capital causes large burdens on companies due to the amount of cash required to sustain a profitable working capital position, The cash burden imposed by working capital is the second-most-common reason companies experience financial difficulty, with failure to generate a profit year-over-year as the most common. Overdependence on working capital requires a lot of cash, which can make it difficult to pay suppliers and even employees, The amount of working capital a company requires depends on the business model of that particular company, the industry in which it operates and how it positions itself with its customers,
For example, companies that rely on selling inventory to generate revenues (e.g., tire stores, grocery stores, etc.) employ aggressive working capital strategies to ensure the company meets obligations as they come due, Companies that do not rely on selling inventory to generate revenues (e.g., tow truck companies, transportation companies, etc.) employ a different working capital strategy as they depend more on their fixed assets (assets purchased for long-term use and not likely to convert to cash quickly) to generate sales instead of their current assets.
Accounts Receivable Impact on Working Capital
Fast-growing companies require more working capital, particularly companies that extend credit to their customers instead of collecting cash payments by creating an asset known as accounts receivable. Accounts receivable work much like a loan, wherein a company sells their good to a customer on credit, Each month that customer pays the agreed-upon payment back to the company until the customer pays back in full that receivable (i.e., loan).
For example, a car dealer purchases 1,000 tires at $200 per tire from a tire manufacturer using credit over a five-year term instead of paying cash up front, This transaction creates a $200,000 account receivable due to the tire manufacturer. As such, that tire manufacturer has extended $200,000 worth of goods to the car dealer, meaning the manufacturer has $200,000 in cash tied up in this account receivable. The tire manufacturer in this situation requires a lot of cash to sustain its working capital as it must still pay its suppliers/vendors for the materials to make tires while it waits for the car dealer to pay the $200,000 in full over the next five years.
Working Capital Productivity
This ratio examines if a company has invested a sufficient amount in working capital to support its sales through the operating cycle by linking its balance sheet to the income statement. Remember that an increase in assets is a use of cash. Thus, if a company sees increasing accounts receivable and inventory, it must maintain enough cash to sustain sales since the increases in accounts receivable and inventory not only requires additional cash, but also ties up the initial cash investment for those increasing current assets for a longer period.
This lack of cash can wreak havoc on the income statement, as the company cannot support increasing sales, which makes it harder to sustain daily operations of the company. The working capital productivity ratio helps companies determine if a company's working capital has enough funding to support its sales.
To determine if working capital is sufficient enough to support sales, calculate the working capital productivity ratio as follows:
Annual net sales Total working capital
For a company to use this ratio throughout its fiscal year, managers should annualize quarterly sales to convert the ratio into a short-term measurement instead of waiting until year-end. Annualizing monthly sales yields even shorter-term measurements to help ensure the company is continually investing enough working capital to support sales throughout the year.
Managers must take into account seasonal sales spikes to avoid matching high annualized quarterly/monthly sales against depleted accounts receivables and inventory levels, thus producing a misleadingly high ratio. Failing to take these steps could indicate that the company's working capital is sufficient to support sales when in reality, a seasonal spike could cause a company to mistake the amount of working capital funds necessary to support sales,
Continuing with the tire manufacturer example, the company reports the following financial position for fiscal year ending 2017:
Sales $20,000,000 Cash $1,000,000 Accounts Receivable $5,300,000 Inventory $8,800,000 Accounts Payable $5,000,000
Calculating the working capital productivity;
$20,000,000 (Annual sales) (($1,000,000 Cash + $5,300,000 Net A/Rs + $8,800,000 Inventory) - $5,000,000 A/Ps)
1.98:1 Working capital productivity
The 1.98 ratio indicates that the company has invested a sufficient amount in working capital to support sales, However, managers should not view this ratio in a vacuum, While the company's working capital was sufficient to support sales during 2017, comparing this ratio against its competitors and benchmarking it against industry standards provides more insight for management to determine if the company's working capital is financially efficient enough to maximize sales,
If the Industry standard Is higher (e.g., 3: 1 working capital productivity), then the company might be losing cash to their competitors through slow accounts receivable and inventory turn. If the industry standard is lower (e.g., 1.25:1 working capital productivity), then the company may have an inventory and/or accounts receivable issue that needs to be addressed, such as obsolete inventory or a large amount of overdue receivables.
Although working capital and working capital productivity provide companies with insight on their abilities to meet upcoming obligations, companies should not consider them as "pure" liquidity measures; however, both measurements still help companies address financing needs to maintain present liquidity,
Since companies calculate working capital using the balance sheet, which only uses values at that point in time during the fiscal year, managers will gain more insight into their liquidity needs if they calculate these measurements on a rolling basis (e.g., monthly, quarterly, etc.) and plot these measurements over time to identify trends, Incorporating trend analysis when tracking these measurements yields patterns and helps managers anticipate when the company may need to prepare to secure additional financing (through equity or debt) to maintain operations,
Additionally, companies should compare their working capital and working capital productivity figures against their immediate competitors and benchmark their measurements against industry standards to help managers determine if they are maximizing their working assets and working liabilities to optimize sales and profits com pa red to that of their peers and the industry. Comparing their companies against that of their competitors and the industry yields further insight for managers to determine if they are losing or saving money against competitors.
Working capital and working capital productivity help monitor liquidity but should be used to supplement forecasts and cash budgets as opposed to replacing them altogether. Managers should not use these measurements to replace forecasts and cash budgets, but simply as tools to incorporate into projections.
As the lifeblood of a company, managing working capital must be a top priority to ensure sufficient funding for a company's operations, as well as the potential to capitalize on any sales growth opportunities and efficiently manage their balance sheets for optimal cash flows.
Ryan Thomas, CRC, CERO, is the CEO of Innovative Risk Consultants, LLC, a company he founded with a partner to help clients drive profits, increase firm value and maximize shareholder and stakeholder returns through proprietary and innovative statistical models and data analytics using risks as opportunities instead of threats. Ryan graduated with his BS in Aerospace Studies from Embry-Riddle Aeronautical University in 2003, Shortly after beginning his career in banking, he received his MBA from Louisiana State University Shreveport. Ryan graduated from the Graduate School of Banking at LSU in Baton Rouge. In April 2017, he achieved his Credit Risk Certification[R] (CRC) designation from the Risk Management Association, He can be contacted at firstname.lastname@example.org.
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|Date:||Feb 28, 2019|
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