The working capital workout

First up, what do we actually mean by working capital? Working capital is the money tied up in debtors (customers who haven’t yet paid) and stock minus what you owe your suppliers (creditors). The important point to appreciate is that as the business grows, the working capital requirement will also grow and this explains why you get fast-growing, profitable businesses going bust – they run out of access to working capital.

From the courses I run, working capital is one of the least understood and most overlooked areas of financial management. This is especially true for entrepreneurs from big corporates who rarely have anything to do with working-capital management.

So, how do you get the working capital pumping? Well, as the cliché goes: to manage it, you have to measure it! So I am briefly going to explain how to measure your working capital efficiency.

The key with management information is to get a suitable ratio and then watch the trend – it’s not the absolute value that is important. As your sales increase, for instance, so will the amount owed to you (all other things being equal), so you need a ratio to see if the amount outstanding is getting bigger or smaller in proportion to your sales. The ratio to use is called “debtor days” and here is the method to calculate it:

1. Take your last three months of credit sales and divide it by the number of days in those months. This gives you an approximation of your average daily sales.

2. Take the balance owed to the company at the end of this period, and divide by the result in 1. This give you a figure for the number of days sales that are tied up in debtors.

3. Do the same exercise either for the previous quarter or, if your business is seasonal, the same period last year or both.

Compare the results. If you have a higher figure (ie: great debtor days), then your credit control need investigation.

Here’s an example:

Sales in three months ending 31 December: £184,000

Days in period: 92

Debtors balance at 31 December: £90,000

So…

Average daily sales: £184,000/92= £2,000

Debtor days: £90,000/£2,000 = 45 days

The same calculation method applies to “creditor days” (creditors/average daily cost of goods sold), and also stock days (stock/daily cost of goods sold). 

You can now work out your cash “heart rate” or cash cycle which is debtor days plus stock days less creditor days. Now you can measure working capital, make it a key part of your business work out!

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