Sunday, 21 June 2009

Key Working Capital Ratios & Sources of Additional Working Capital

Stock Turnover(in days)
Average Stock * 365/Cost of Goods Sold
= x days
On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management.Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.

Receivables Ratio(in days)
Debtors * 365/Sales
= x days
It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ?One or more large or slow debts can drag out the average days. Effective debtor management will minimize the days.

Payables Ratio(in days)
Creditors * 365/Cost of Sales (or Purchases)
= x days
On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.

Current Ratio
Total Current Assets/Total Current Liabilities
= x times
Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.

Quick Ratio
(Total Current Assets - Inventory)/Total Current Liabilities
= x times
Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.

Working Capital Ratio
(Inventory + Receivables - Payables)/Sales
As % Sales
A high percentage means that working capital needs are high relative to your sales.


An example:

Company A monthly inventory = $30
Company A annual purchases = $360
Inventory turnover = $30 x12 / $360 = 1 month = 30 days

The bank gives a interest free facility for the first 15 days; after then, interests will be charged on a daily basis from the first day of purchase.

The company presently uses the bank facility of $30.

How can this company manages its cash flow better? How can this company saves on its interest payment?

Company A can continues to enjoy the bank's interest free facility if it can get its inventory turnover to be less than 15 days. This will free up working capital that can be used for other parts of its business.

To save on interest, company can increase its own working capital by injecting cash in the form of equity or a loan from owners. This cash can be used to settle the bank facility at the time period of 15 days, that is, before the facility incurs interest charges. How much cash should be injected into its working capital for this? To do so, would require (15 days/30 days ) x $30 = $15 cash to be injected in the form of equity or loan by the owners, for extra working capital.


Sources of Additional Working Capital

Sources of additional working capital include the following:

  • Existing cash reserves
  • Profits (when you secure it as cash !)
  • Payables (credit from suppliers)
  • New equity or loans from shareholders
  • Bank overdrafts or lines of credit
  • Long-term loans

If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading.

Early warning signs include:

  • Pressure on existing cash
  • Exceptional cash generating activities e.g. offering high discounts for early cash payment
  • Bank overdraft exceeds authorized limit
  • Seeking greater overdrafts or lines of credit
  • Part-paying suppliers or other creditors
  • Paying bills in cash to secure additional supplies
  • Management pre-occupation with surviving rather than managing
  • Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).
For information on cash flow planning, see Making Cash Flow Forecasts, Cashflow Plan software and Checklist for Improving Cash Flow.

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