|
Why Reduce Working Capital?
Cash flows in a
cycle into, around and out of a business. It is the
business's life blood and every manager's primary task
is to help keep it flowing and to use the cashflow to
generate profits. If a business is operating profitably,
then it should, in theory, generate cash surpluses. If
it doesn't generate surpluses, the business will
eventually run out of cash and expire.The faster a
business expands, the more cash it will need for working
capital and investment. The cheapest and best sources of
cash exist as working capital right within business.
Good management of working capital will generate cash
will help improve profits and reduce risks. Bear in mind
that the cost of providing credit to customers and
holding stocks can represent a substantial proportion of
a firm's total profits.
There are two
elements in the business cycle that absorb cash -
Inventory (stocks and work-in-progress) and
Receivables (debtors owing you money). The main
sources of cash are Payables (your creditors) and
Equity and Loans.
Each component
of working capital (namely inventory, receivables and
payables) has two dimensions ........TIME ......... and
MONEY. When it comes to managing working capital -
TIME IS MONEY. If you can get money to move faster
around the cycle (e.g. collect monies due from debtors
more quickly) or reduce the amount of money tied up
(e.g. reduce inventory levels relative to sales), the
business will generate more cash or it will need to
borrow less money to fund working capital. As a
consequence, you could reduce the cost of bank interest
or you'll have additional free money available to
support additional sales growth or investment.
Similarly, if you can negotiate improved terms with
suppliers e.g. get longer credit or an increased credit
limit, you effectively create free finance to
help fund future sales.
|
If you ....... |
Then ...... |
|
u
Collect receivables (debtors)
faster |
You release cash from the
cycle |
|
u
Collect receivables (debtors)
slower |
Your receivables soak up cash |
|
u Get better credit (in terms
of duration or amount) from suppliers
|
You increase your cash
resources |
|
u Shift inventory (stocks)
faster |
You free up cash |
|
u
Move inventory (stocks)
slower |
You consume more cash |
It can be
tempting to pay cash, if available, for fixed assets
e.g. computers, plant, vehicles etc. If you do pay cash,
remember that this is now longer available for working
capital. Therefore, if cash is tight, consider other
ways of financing capital investment - loans, equity,
leasing etc. Similarly, if you pay dividends or increase
drawings, these are cash outflows and, like water
flowing down a plug hole, they remove liquidity from the
business.
|
More businesses fail for lack
of cash than for want of profit. |
Key Working Capital Ratios
The following, easily
calculated, ratios are important measures of working
capital utilization.
|
Ratio |
Formulae |
Result
|
Interpretation |
|
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. |
Other working capital
measures include the following:
- Bad
debts expressed as a percentage of sales.
- Cost of
bank loans, lines of credit, invoice discounting
etc.
- Debtor
concentration - degree of dependency on a limited
number of customers.
Once ratios
have been established for your business, it is important
to track them over time and to compare them with ratios
for other comparable businesses or industry sectors.
|
