by Michael Iverson
I often remind clients to pay attention to their working capital levels, particularly in today’s economic environment, when banks have shown a reluctance to lend to small businesses. Business owners need to maintain liquidity, generate positive cash flow and – to the extent possible – prepare to fund growth internally. Working capital is critical to your financial dashboard, a tool we recommend you as a business owner use to monitor your financial health.
Understand Working Capital
Let’s begin by defining working capital. Simply stated, it is the difference between current assets and current liabilities. A common perception is that a profitable business always has adequate working capital; however, that is not necessarily true. Profitable businesses can, and do, experience capital crunches. Often, an effort to expand operations aggressively is the cause of a shortage of working capital.
Working capital is composed of primarily of Accounts Receivable, Inventory, and Accounts Payable. A business owner needs to consider changes to these short-term assets and liabilities in order to ensure the business generates adequate operating cash flow.
For example, an increase in Accounts Receivable might mean a business is falling behind its in collections. Sales offered on credit, a business is effectively making a non-interest bearing short-term loan to its customer. Collecting accounts promptly is important. An aged invoice that goes past its due date can have a negative effect on cash flow. The business used precious resources to bring a product to market and sell it, but until the account is collected those funds are unavailable.
For my clients that extend credit, I recommend a dashboard metric called Days Sales Outstanding (“DSO”). It measures the relationship between Accounts Receivable and Sales. When this metric spikes higher than a specified level, then collections are not keeping pace. A quick glance at the dashboard shows you the trend of the metric. Measuring and understanding the drivers of the metric can help you identify where to make changes.
For businesses with inventory, it’s important to make sure that inventory is not consuming capital unnecessarily. Is inventory getting sold on the schedule? As with aging Accounts Receivable, a buildup of inventory ties up your cash resources when it is not converted to cash on a timely basis. The Inventory Turnover Ratio is a dashboard metric that highlights this trend. When the ratio decreases, it can signal an upcoming cash flow problem.
Another balance sheet account in working capital is Accounts Payable. Accounts Payable is the opposite of Accounts Receivable, where your business has been extended a short-term interest free loan from your vendor. When a business slows down its vendor payments, it is conserving cash. A business will at times use this strategy when it is experiencing slower payments in Accounts Receivable. Days Payable Outstanding (“DPO”) is a metric that measures your payment cycle trend. Consider putting it on your dashboard. Measuring your DPO helps identify when you may be disbursing funds faster or slower than expected.
Working Capital Ratios
To recap, here are the Working Capital ratios that I recommend you measure:
- Days Sales Outstanding
- Inventory Turnover Rate
- Days Payable Outstanding
If you don’t understand the relationship of these metrics on your operating cash flow, your business can quickly become a very profitable operation that is very quickly running out of cash.
Developing a financial dashboard helps you manage review key metrics to gain insights on making decisions for your business. Schedule a free consultation with our Numbers Coach, where we are glad to discuss metrics that make the most sense for your business.