Working capital is a simple concept that can give an immediate indication on how a business is travelling. It is the difference between the current (short term) assets and current (short term) liabilities.

It is the business’ liquidity, which I have covered, in a previous Blog. Hopefully your business is liquid and not in a “desert” (ie you have more current assets than current liabilities). In this Blog I want to focus on what makes up your current assets and how you can be more effective with these assets.

There are 3 components to your current assets - cash, stock and your debtors. Cash is self-explanatory ie what money you have on hand or in “the bank”. The other two warrant further explanation.

Organisations (importers and manufacturers) that supply products to customers need to carry stock. Even manufacturing organisations that are truly Made To Order (MTO) businesses need to carry some stock that will subsequently be use in their fabrication process. It costs money to purchase stock. This money is taken out of the business’ cashflow to secure the stock. It is not recovered until the purchased items are paid for and that money is in your bank account. Similarly, if your invoices are not paid on time by your customers (debtors in the accounting speak), then this is less money available for you as the business owner to use on other critical business activities, such as paying bills.

Stock

Ideally we have exactly what the customer wants at a location near to the customer. The likelihood of this is minimal, as even our customers probably don’t know exactly what their customers want. So we carry a variety of items in a variety of sizes and shapes, which we store in a warehouse, waiting for our customers to order. This is our stock. The challenge is to have the right stock at the right location. The consequence of getting this wrong is that stock sits in the warehouse for a long time before moving (Slow Moving Stock) or worse, doesn’t move at all (Obsolete Stock). In the latter case, the customer no longer wants this product and you are stuck with it. Slow Moving or Obsolete stock ties up cash which could be better used for buying stock that sells or investing that the money back into the business.

As a business owner you must review your stock with particular focus on Slow Moving and Obsolete stock. Proactive organisations use the concept of Stockturns as a guide to whether their stock is selling or not. This helps to highlight if there is a problem. The most commonly used formula is:

Stockturns    =       Cost of Goods Sold

                               Average Inventory on hand

It is an efficiency ratio, which measures how effectively inventory is managed. This ratio compares the cost of a good sold with the average cost of inventory held for a period. It measures how many times inventory is "turned" or sold during the period nominated (usually 12 months). It can be used for individual items but is more commonly used as a measure of the total stock holding. To clarify with an example, if in a year an organisation sells goods that cost $480,000 and the average stock holdings costs for the year was $120,000, then the stockturns for the year is 4 ie the stock on average is sold 4 times a year. Applying this to a specific product, let’s say you have stock that would sell for $12,000 with a purchase cost of $8,000. If this stock sits in your warehouse then you have $8,000 tied up in stock that you have paid your supplier. If it sits in your warehouse you also have not recovered your $4,000 Gross Profit (difference between sale price and purchase cost; $12,000-$8,000). This is bad enough, but using the stockturn of 4, calculated previously, the $4,000 should have been recovered 4 times and therefore the lost opportunity is really a yearly loss of $16,000!!!!

It is easy to see the drain on an organisation’s cash, if stock is not controlled.

You must determine how you will handle stock and not allow it to soak up all of the businesses cash. You are in control of your business and you should determine where your cash is spent. I know one very successful business owner who has consciously made the decision to hold stock for all his customers, irrespective of how often it sells. That business is the go to organisation for anybody who wants items in that industry. It is one of that business’ competitive advantages. That owner has made the decision to hold stock. He has significant cash tied up in stock, but has determined that this is a significant part of his businesses success. He also understands the consequence of this strategy.

Debtors

The other aspect of Working capital that too often gets overlooked is the non-payment of Invoices by customers. If your customers do not pay you in a timely manner, this in turn impacts the amount of money you have to pay your bills or purchase stock. Many businesses handle late payment of invoices through bank overdrafts (7-9%) and loans (5-6%). The interest paid is a further cost to business. Attention paid to collecting money could reduce, minimised or eliminated costs associated with bank interest. Bad debts or the inability to collect debts is a leading cause for bankruptcy the world over. In Australia, we often see the impact of large organisations withholding payment or indeed renegotiating payment terms, which are crippling for SME’s.

A measure of debtor days is used to determine how quickly your invoices are paid. The most common calculation is:

Debtor days   =      Trade debtors   x Days of Sales (usually 365 days)

                                Total sales

Comparisons for the same business over different periods of time are most often used. Comparisons of companies in different sectors are rarely meaningful as the differences are usually largely the result of the nature of different businesses.

So using an example of total of unpaid Invoices of $253,000 and an annual revenue of $2,300,000, this gives us a debtor days of 40.15 days ($253,000/2,300,000*365 = 40.15). This means that on average customers are taking 40.15 days to pay their invoices. If the average for the industry is 30 days, this means this business owner is giving the customers an extra 10.15 days to pay their invoices. This equates to an extra $63,960 of credit annually (10.15 days*$2,300,000/365 days/yr). It also means that the competition is being paid more quickly (remember in this example the industry average is 30 days) and therefore has more available cash to reinvest in its own business. I have seen a business unsuccessfully try to recover unpaid invoices that were 7 years old (how could this be!!!). Don’t let the debtor days become larger than the industry average. You are in control of your business and you need to ensure you have control of your cash.

Focus on your working capital and ensure that your current assets are monitored and managed to maximise your business’ cashflow.

If you have any questions about this or would like some help to improve your Working Capital please e-mail Robert on This email address is being protected from spambots. You need JavaScript enabled to view it.