Preface: Don’t tell me what you value, show me your budget, and I’ll tell you what you value.” –Joe Biden.
Working Capital Tools for Successful Business Performance (Segment III)
Credit: Donald J. Sauder, CPA, CVA
Working Capital Measurements
Working capital is an easy calculation (current assets minus current liabilities equals working capital). Working capital measures the operational liquidity level of a business. Currents assets are primarily the cash and equivalents accounts, accounts receivable, vendor prepayments, and inventory. Current liabilities are primarily accounts payable, credit cards, line of credit, tax liabilities, accrued expenses, customer prepayments and deposits, and current portions of debt.
To accurately measure working capital, it is necessary to have accurate financials with appropriate accountant oversight to classify accurately current and noncurrent assets and liabilities. The current ratio applies the same financial numbers as working capital, yet instead of subtracting current liabilities from current assets, the current ratio divides current assets by current liabilities. Typically, a current ratio should be greater than two and likely 2.5, to be solidly established from an analytical measurement metric.
Working capital measurement and management are synonymous; an analytical approach to monitor a business’ capacity to continue operations with sufficient cash flows and to pay operating expenses and satisfy short-term debt obligations.
Sauder and Stoltzfus, and an entrepreneurs CPA firm, has developed a working capital grading tool to help clients measure optimal working capital levels, i.e. how much is enough when discussing working capital? Let’s call it the working capital grader.
Working capital seems easy enough to calculate. You look at your financial statements and subtract current liabilities from current assets. If you should have the financial accuracy to calculate the balance, the numbers independently, do not provide much analytical guidance. Tracking the balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”
Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.
Here’s how we grade working capital at our firm. You can do math or follow along (current assets minus current liabilities is the formula.) Now contrasting that mathematically to the profit and loss statement, measure your direct labor expenses,+ operational or general and administrative expenses on a quarterly basis, e.g. what do you pay in direct labor expense or general and administrative expense, on average, every three months?
A business with a direct labor expense of $1,000,000 per year, you would multiply the twelve- month fiscal year number by 0.25; that calculates to $250,000 per quarterly ($1,000,000 * 0.25). If your operating expenses or general and administrative expenses are $1,200,000 for the twelve-month fiscal year, then you would multiple that balance by 0.25 to arrive at a calculated $300,000 ($1,200,000 * 0.25). The greater of those two numbers is your optimized working capital or $300,000, e.g. your business is a solidly pillared if you have the greater of these two numbers in the working capital formula.
If you have working capital in-excess of the calculation your business can take on additional risk to safely develop the expansion of operational activity.
Now if working capital (current assets in the hypothetical business are $900,000 and current liabilities are $725,000) at $175,000, the $175,000 compared to the optimized $300,000 provides an accurate measurement and comparison; $175,000 is what is; $300,000 is the goal for optimization.
Here it is, the grading tool:
- 35% equals one month of working capital
- 70% equals two months of working capital
- 100% equals three months of working capital.
In the above calculated working capital scenario, the 175,000/$300,000 is a lackluster 58% grade. If your business working capital grade is below 5%, your business likely needs immediate help from “Now Man Central”. On the other hand, the $125,000 increase required from $175,000 to achieve $300,000 can be obtained with additional earnings and profits retained in the business, or long-term amortization of say a line of credit.
For a well-managed business, it is an achievable goal to work towards, and exceed a 100% working capital grade; For entrepreneurial businesses with optimized working capital at 100%, say “Happy Birthday!”
Now comparing this to the current ratio; the current assets of $900,000 divided by $725,000 of current liabilities equals a current ratio of 1.24. A current ratio of greater than 2 would require more than $1,450,000 of current assets say in this hypothetical calculation with no changes in current liabilities.
Typically, as an entrepreneur builds equity with profitable earnings, liabilities decrease as they are paid, and equity increases. Therefore, the measurements and grades improve with time. Startup business ventures should appreciate that their largest risk is liquidity, i.e. measured as working capital.
Working capital tools advisedly should be continually applied and monitored for businesses in every industry.
Summary: “How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case”. –Robert G. Allen