Having sufficient working capital is a key to all successful businesses. As demonstrated below – the irony is that challenged entities required more working capital than their non-challenged counterparts.
Working capital requirements play a disproportionate role for two diverse ends of the business spectrum – those that are growing significantly and those that are experiencing a downturn in business. For the purposes of this illustration, allow me to focus on the challenged entities.
In general, we can see that the working capital requirement increases as inventory and amounts owing by customers (accounts receivable) increase, and reduces as the amounts owed to suppliers (accounts payable) increases. This is summed up in the formula:
NET WORKING CAPITAL REQUIREMENT = INVENTORY + ACCOUNTS RECEIVABLE – ACCOUNTS PAYABLE
To compare “apples to apples”, we need to convert each of the aforementioned working capital components to a standard measurement – that standardized measurement being a percentage of revenue.
As the business deteriorates, its revenues decrease, which in turn decreases the accounts receivables due from customers and generally impacts inventory on hand.
At any given point a business needs to be able to estimate its working capital requirements. As the revenue figure is normally at hand or the first to be forecast, the simplest way to do this is to calculate the working capital requirement as a percentage of revenue. The working capital requirement is a function of accounts receivable, inventory and accounts payable. Allow me to illustrate this working capital requirement. For simplicity purposes, let us assume that revenue is $18,500,000, gross profit margin is 40%, with the number of days inventory held being 45 days, accounts receivable terms are 45 days, and an average days of credit for accounts payable being 30 days.
In this scenario, the working capital requirements is 14.8% of the Revenue. Or $2,700,000 required working capital. Although this figure will change overtime, providing the business is relatively stable, it gives a good indicator of what the potential working capital requirement is for the business.
Let us modify the aforementioned scenario by having the Revenue decrease 20%, Gross Profit Margin decrease 8% (as a result of lost in economies of scale and lack of capacity optimization), and this company suffers from decrease in inventory turns (assume inventory held is an average of 60 days).
As a result of the decrease in business based upon these assumptions, the net working capital required has increased to 20.7% of revenue. Or a relative increase in net working capital of 5.9% between the two scenarios. This 5.9% relative change equates to $303,000 more cash required for the second scenario despite the decrease in size. To make this net situation worse the company would have the same debt service and fixed costs to address with significantly less cash.
With "cash is king" mantra - understanding and optimizing your required cash flow is as important, if not more, than understanding the profit and loss statement.