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Unlocking The Mystery Of Working Capital

Unlocking the Mystery of Working Capital

At Third Road Management we have the honor of working with businesses and non-profits across a spectrum of industries, ownership structures, tenure and financial status. Through our experience we have gathered some wisdom that can hopefully be helpful to business leaders outside of our current network of clients. This is our venue to share some of our ideas.

In this blog post we would like to take some time to talk about working capital, a term that we continue to find perplexes a lot of small to mid-sized organizations.  Specifically we are going to address: 1) What is working capital?  2) Why does working capital matter and how much do you need? 3) What about a line of credit? 4) How to accurately measure working capital, and 5) What are helpful working capital metrics to look at?

So here we go…

  1. What is Working Capital?  In the simplest terms, working capital is the measure of the current assets on your balance sheet (eg- cash, short term investments, accounts receivable and inventory) less the current liabilities on your balance sheet (eg- accounts payable, the current portion of long-term debt, accrued liabilities, etc.).  In short, working capital is a measure of liquidity that calculates an organization’s ability to meet its short-term obligations with its short-term assets.
  2. Why Does Working Capital Matter and How Much Does an Organization Need?  There are two major reasons why working capital matters.  First, everyone should desire for their organization to be in a position of strength to easily weather any potential bumps in the road without getting anxious about the stability of the organization.  Nobody wants to lead from a position of weakness.  Secondarily, in the event that an organization is looking to sell, a business’ normal working capital position is something that an investor will consider in deciding what to pay to acquire a business.  As a rule of thumb, organizations should aim to hold 2-6 months of normal course operating expenses in net working capital.  The more stable and predictable the business is, the lower end of that range should be ok.  The more seasonal, cyclical, or generally unstable a business is, the more the end of that range would be appropriate.  Each situation is unique and things can change over the course of time, but the management team of an organization should continually discuss and adapt.
  3. What About a Line of Credit?  Small to mid-sized organizations typically solve their working capital concerns utilizing a working capital line of credit from a bank.  There are pros and cons to this.  The cons are that means the business is paying interest (not ideal) and that it could be indicative of a business that is unable to manage and fund its liquidity on its own.  The major pros to a line of credit are that it may offer inexpensive financing, it can be a very helpful tool to fund growth in a business when used properly, and it is particularly helpful in industries with significant lags in collections vs. cost incurrence (long payment terms).  So, a good question to ask is whether or not the line of credit is being used to fund growth or stabilize the liquidity of a business.  If a line of credit has had balances outstanding for a number of years and growth has been tepid or worse, there is a pretty good chance it is the latter.
  4. How to Accurately Measure Working Capital?  The calculation of current assets – current liabilities = net working capital is straight forward; however, you need to make sure that the inputs you are using are accurate and true of the business otherwise you will end up in a garbage in/ garbage out scenario.  For example, on the current asset side of the equation you’ll want to make sure that your accounts receivable are up-to-date and net of any anticipated bad debt reserves.  Additionally, your inventory should be updated to reflect any book vs. actual adjustments and write-offs for any slow moving or obsolete items.    On the current liabilities side, you’ll want to make sure that your accounting practices include actually entering accounts payable on a routine basis and making appropriate accounting accruals (eg- accrued payroll).  Another example would be to make sure to include the current (within 1 year) portion of any long-term debt or leases.  If you don’t have solid accounting practices to measure your working capital position, its utilization as a tool will be muted.
  5. What are Helpful Working Capital Metrics to Look at?  Here is a list of a few helpful measures of working capital health for your management team to measure regularly (at least monthly) and establish KPI’s for:
    1. Net Working Capital/ Monthly Operating Expenses: This measures the months of operating cash on hand to help fund the business.  As mentioned previously, a good goal is to have 2-6 months on hand depending on a variety of factors.
    2. Current Ratio (Current Assets/ Current Liabilities): If the current ratio is less than 1 this is an indication that liquidity is an issue.  Conversely an exceptionally high current ratio may be an indication that an organization is not efficiently managing its cash and may have investment opportunities.  In general a current ratio of greater than 1 is a good starting point for a discussion on health, but management should also consider other factors such as industry norms, seasonality, cyclicality, etc.
    3. Days Sales Outstanding (DSO’s): This measures the time it takes, on average, for an organization to collect on its revenues.  The shorter the better and this should be compared to a business’s standard payment terms to determine how it’s doing on collections.  The calculation for DSO’s= (Average Monthly A/R Balance/ Annual Sales) * 365.
    4. Days Payables Outstanding (DPO’s): This measures the time it takes, on average, for an organization to pay its bills.  The longer the better (although too long is a sign of unhealth and may lead to angry vendors) and this should be compared to a business’s standard payment terms to determine how it’s doing on payments.  It isn’t uncommon for accounts payable clerks to pay too fast to get more items off their plate.  Or, conversely, you may find that taking advantage of offered vendor early payment discounts is good for your bottom line.  The calculation for DPO’s = (Average Monthly A/P Balance/ Annual COGS) * 365.
    5. Days of Inventory on Hand (DIO): This measures the days of inventory, on average, kept by an organization.  The higher the number of days of inventory kept on hand may be indicative of slow moving inventory and/or inefficiencies in managing working capital (and space utilization).  Conversely, if DIO’s are very low it could be indicative of supply chain issues and inability to meet customer expectations…which nobody wants.  The calculation for DIO = (Average Monthly Inventory Balance/ Annual COGS) * 365.
    6. Cash Conversion Cycle (CCC): This measures the number of days it takes from receiving an item into inventory and converting the product to cash from a sale to a customer.  The goal would be for this to be as short as possible without disrupting business operations.  The formula for the CCC = DSO + DIO – DPO.

This blog is intended to act as a primer for understanding working capital and how to use this understanding to better lead an organization.  This is not exhaustive of the conversation or the metrics that can be utilized, but it is a start to build upon.  All metrics should always be measured over a period to time to better understand trends and areas for potential improvement.

At Third Road Management our expertise lies in everything helping you lead strategically, financially and operationally, so if you need any help always feel free to contact us at for a no-obligation initial cost consultation.

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