This is the third in a series of articles entitled Know Thy Numbers: The Eleventh Commandment. This
article focuses on working capital: the definition of working capital, how it is measured, and its importance
to the continued operations of the company.

Working capital is a measure of company liquidity and is the difference between current assets and
current liabilities. Current assets include cash, net accounts receivable, inventory and other assets that
will be consumed or converted into cash within 12 months. Current liabilities include accounts payable,
accrued expenses, and other liabilities that will be paid within 12 months, including the current portion of
long-term debts. The greater the positive working capital, the more liquid the company, and the greater
the certainty that the company will be able to meet its obligations as they become due. Conversely, the
lower the working capital, or, god forbid, if working capital is negative, that is if current liabilities exceed
current assets, the greater the danger that the company will not be able to meet obligations, including
payroll, as they become due.

While effective management can improve the company’s working capital, ineffective management can
diminish working capital. Poor management, including poor planning, can reduce working capital to such
an extent that the company cannot meet its obligations, leading to the eventual demise of the company.
There are numerous ratios that are commonly used to measure liquidity. The most common of these are:

Current Ratio = Current Assets / Current Liabilities;
Quick Ratio = (Current Assets – Inventory) / Current Liabilities);
Receivables (Days) = Accounts Receivable / Average Daily Sales;
Inventory (Days) =Inventory / Average Daily Cost of Sales; and
Payables (Days) = Accounts Payable / Average Daily Purchases.

Optimal ratios differ by industry, and your financial professional can provide you with benchmark numbers
for your industry, and he/she should also be able to advise you as to the adequacy of your working
It’s relatively easy to determine whether you are having liquidity issues. Some of the more frequent signs
of a liquidity crisis include:

  • Payables becoming increasingly old;
  • Receiving demanding phone calls from creditors;
  • Increasing balance on line(s) of credit or consistently utilizing the entire line of credit;
  • Carrying balances on company credit cards;
  • Not having adequate funds to make tax payments;
  • Deferring necessary maintenance; and

Increasing accounts receivable and/or inventory levels without pro-rata sales increases.There are many reasons that may cause a company to experience liquidity problems, and it is critical for
companies to monitor these possibilities in order to prevent such problems from occurring or to solve the
problems as quickly as possible.

Frequent causes of liquidity problems include:

  • Increases in past-due accounts receivable;
  • Customers paying invoices short due to poor quality or invoicing problems;
  • Purchasing too much or wrong inventory due to poor sales projections or errors in ERP systems;
  • Ineffective systems and/or procedures causing the company to incur excessive costs, including
  • excess labor;
  • Employee theft and/or waste;
  • Starting a business with inadequate capital;
  • Drawing too much capital out of the business; and
  • Lack of planning or poor planning.
  • There are certain actions that management can take in order to ensure adequate working capital. Such
  • actions include:
  • Checking customer credit references;
  • Establishing firm credit policies, including payment terms and customer-specific credit limits;
  • Invoicing customers promptly and accurately to reduce collection cycles and disputes;
  • Issuing monthly accounts receivable statements;
  • Contacting customers prior to invoice due date to address potential payment issues, and
  • continuing to follow up on receivables after they become due;
  • Considering the use of credit insurance;
  • Encouraging customers to pay with credit cards;
  • Consider offering discounts for early payment;
  • Constantly monitor and update detailed sales projections;
  • Ensuring the accuracy of bills of materials;
  • Adopting “just in time” inventory procedures for purchase of raw materials and components;
  • Reducing inventory levels and monitoring closely to minimize excess or slow moving stock;
  • Negotiating with suppliers for longer payment terms;
  • Negotiating with suppliers to maintain inventory at their location; and
  • Ensuring that the company has adequate internal controls.

While the above-mentioned measures can help improve working capital, management must take care to
manage unintended consequences. Establishing credit limits that are too tight may cause the loss of
sales or the loss of customers. Collection calls, if made by an abrasive individual, can have a similar
impact. Early payment discounts can be very expensive, especially at today’s low interest rates, and
trying to adopt a “just in time” inventory is inappropriate for certain industries, and can lead to lost sales if  the company’s supply chain cannot support such a policy. Additionally, stretching vendor payments may cause vendors to increase your prices and may lead to the loss of a critical vendor.

How much working capital do you need for your business? Again, this differs tremendously from
company to company, and may change over time. Knowing your current liquidity position, while critical, is
not sufficient to ensure that the company maintains adequate liquidity. To know how much you need
requires planning, not just a budget, but consistently updated plans covering both the income statement
and balance sheet. A well-executed business plan will present business owners with their changing
capital needs, ensure them of their ability to pay their obligations as they become due and show them
how much cash can be safely withdrawn from the company in any form, whether salary, bonus or
dividends. The failure to plan is one of the major reasons for companies experiencing liquidity problems
and business failure. This will be discussed further in my upcoming Cash Article. B2B CFO®

Partners are experienced in monitoring working capital and implementing the appropriate
changes that will strengthen the overall financial condition of the company. Management of working
capital is another example of how we reduce stress on the business owner and allow the business owner
to focus on business development and other critical activities that add value to the business.

Click here to read the second article in the series.

Click here to read the first article of the series.

Learn more about Vince’s experience and capabilities, click here.