Direction Magazine - Ask Dave June 2012
The following was published in Direction Magazine.
By Dave Duryee
I hear a lot about working capital. What exactly is it and how much do I need?
I get this question a lot. Working Capital is necessary in your business to provide adequate liquidity to pay your bills when they are due. Even though it is one of the most important financial components in your business, there is remarkably little understanding about what it is and how much is ideal for you to have. The fact is that a shortage of working capital and the resulting lack of liquidity is the leading cause of business failure, and monitoring it is therefore very important.
Working Capital is defined as Current Assets (those assets that will turn to cash within a 12 month’s time period) minus Current Liabilities (those liabilities that are due within a 12 month’s time period). Examples of Current Assets include cash, accounts receivable, packing supplies and prepaid expenses. Current Liabilities include your line of credit at the bank, accounts payable, accrued expenses and the current portion of your long term debt.
The Right Amount
So, how much Working Capital is enough? Liquidity is measured by dividing your Current Assets by your Current Liabilities as follows:
Current Assets divided by Current Liabilities
This is called the Current Ratio and a standard for this ratio is 2.00. That would be $2.00 in Current Assets to pay $1.00 in Current Liabilities. The result is that you have $.50 of working capital, as follows:
$2.00 Current Assets
-1.00 Current Liabilities
$1.00 Working Capital
If your Current Ratio is below 2.00 and you need additional Working Capital and you can calculate the minimum Current Assets needed by multiplying your Current Liabilities by 2.. Conversely, you can calculate your maximum Current Liabilities by dividing your Current Assets by 2.
Building Working Capital
If you have calculated your Current Ratio and found that it is less than 2.00 you need to build Current Assets and/or reduce Current Liabilities. This is not going to happen overnight but with adequate focus it should not take a long period of time.
Start by making sure that your accounts receivable are being collected promptly. Your over 60 day accounts should not exceed 10% of the total receivables, and 8% would be better. Get on the phone and get them collected. Get an aging of your accounts receivable at least weekly and work on the ones that are the oldest. Use the money collected to pay your Accounts Payable. Every $1.00 in Current Assets which is used to pay $1.00 in Current Liabilities improves your Current Ratio and therefore your Working Capital.
Make sure that your packing materials are not excessive and put off buying as long as you can without running out. Explore opportunities with suppliers wherein they agree to store their material in your warehouse and only charge you for what you use. Every dollar counts.
Put off any distributions to owners or discretionary payments as long as you can. Watch every dollar that is spent. Think of ways to cut your expenses, at least in the short term. Use any excess cash to pay your Current Liabilities.
In order to build your Working Capital up to where it should be you need to be vigilant and relentless. Understand the dynamics of your Current Assets and Current Liabilities and work them constantly. Set a goal of at least 1.50 for your Current Ratio and measure it every month. Focus on this and it will improve.
Philosophy of Working Capital
Determining an adequate amount of Working Capital for your company depends upon your philosophy regarding paying your bills. If, as an example, you want to pay every bill when it hits your desk, regardless of when it is due, you are going to need more working capital than if you wait 30 days to pay.
On the other hand, if you routinely don’t pay any bills until the creditor calls you (60 days or more), then you will need less Working Capital. Maybe you can get by with a Current Ratio of 1.25, or $.25 in Working Capital. I don’t recommend this and people will not like dealing with you, but you won’t need as much Working Capital.
After more than 30 years of consulting with moving and storage companies I have learned that there is a direct correlation between successful, well run companies and strong Working Capital. Most have a Current Ratio 2.00 ro over and none are under 1.50.
Successful, well run companies have strong Working Capital; it’s as simple as that.