I recently fine-tuned my Financial chops at a week long National Development Association training on economic development finance. It was a tough week, but a good one. I brought back some new tools we can use to analyze companies quickly and efficiently, and help determine debt capacity and operational effectiveness.
Here’s a concept that bears exploration, and one that I find is commonly underestimated by even the best managed companies – permanent working capital.
It’s the cash that’s tied up in your operations. Here’s one way to think about it. When I sold my radio stations in 2000 it was an asset sale – I still owned the accounts receivables and payables. Since radio stations have no physical inventory, this math is pretty easy – At close I started to pay all my left over bills – all the accrued payroll expenses, the snow removal bill, the phone bill, everything up to the date of close. This drained the checking account down, but I was also receiving the income from all the advertising we had sold before the day we handed over the assets of the company.
90 days later all the bills had been paid, and all the receivables collected (with a few write-offs.) What was left over was my permanent working capital.
Calculating working capital requirements isn’t difficult – there are great tools to figure it out. Understanding the concept is important.
There are two concepts of working capital – the first is the Balance Sheet concept – simply the difference between short term assets and short term liabilities, and is a quick method of gauging the debt capacity of a company. Matching asset life and debt terms is critical to make sure that this concept is reflected accurately by the financial statements of a company.
My focus is on the second concept of working capital – the operating cycle.
The uncertain, un-synchronized cycle of payments and receivables. Buy inventory, pay staff, accrue liabilities, make product, sell product, pay bills, get paid, etc. etc.
To calculate your companies cash cycle, take your annual sales (P&L) and divide it by your Accounts receivables from your year end balance sheet. Multiply by 360. this is your average days receivable. If your terms are net 30, and this number is 30-35 – you are doing a great job collecting. Tracking this number over time is a great way to watch for operational effectiveness.
Days inventory = inventory (balance sheet)/COGS*360
You’ll also calculate days payable – accounts payable/COGS *360.
Days Accrual (all your payroll related stuff)/COGS*360.
Now you have all these days – the average turn on inventory – the average length of time it takes to pay your bills.
To calculate your Cash cycle – Days Receivables+Days inventory-days payable-days accruals.
That’s how many days you have of cash tied up in your operating cycles.
What’s the right number? Depends – restaurants have a very short cycle – they buy food for cash and sell for cash the same day. Ship builders have incredibly long cycles – years and years. Dell computer made a billion dollars by figuring out how to pull off a negative cash cycle.
Track it, compare it, understand it. Manage your finances to match short term capital with the seasonal fluctuations, and long term capital with the permanent, necessary portion of working capital.
Questions? The Small Business Development Centers provides free counseling to businesses every day – give us a call!