Preface: Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides an understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.
Surviving a Debt Euroclydon (Segment V)
Credit: Donald J. Sauder, CPA |CVA
Measuring working capital is the second easy tool to help maintain a well-oiled enterprise. Working capital is a balance sheet calculation, or current assets minus current liabilities equals your business working capital. Working capital measures the operational liquidity level of a business.
So what are currents assets? They are often your cash and equivalents accounts, accounts receivable, vendor prepayments, and inventory. Assets that are easily convertible into cash with a year. Current liabilities are often your accounts payable, credit cards, line of credit, tax liabilities, accrued expenses, customer prepayments, and deposits, and don’t forget the current portions of debt.
To precisely measure an enterprise’s working capital, it is necessary to have accurate accounting with appropriate accountant oversight for proper classifications of both current and noncurrent assets and liabilities.
The current ratio applies for 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 higher than two and likely two and a half, to be solidly established from an analytical measurement metric.
….the working capital grading tool is 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 grade. It requires analysis of both the balance sheet and profit and loss statement.
Working capital measurement is an analytical approach to monitor a business’ capacity to continue operations with sufficient cash flows and to pay operating expenses and satisfy current liabilities cash uses.
Sauder and Stoltzfus, as 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 grade. It requires analysis of both the balance sheet and profit and loss statement.
Tracking the working capital balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”
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. You can do math or follow along with current assets minus current liabilities as the formula.) Let’s say the cash $5,000 + accounts receivables $45,000+ inventory $70,000 is $120,000. Now subtracting accounts payable $30,000 + accrued wages $15,000 + current portion of debt $25,000 is $70,000. Now the working capital calculation is $120,000 – $70,000 = $50,000.
In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon.
Next, we compare that working capital level of the balance sheet to the profit and loss statement, measuring both direct labor expenses, and operational or general and administrative costs on a quarterly basis, e.g., what do you pay indirect labor expense or general and administrative expense, on average, every three months? This example can include multiplying a year of data with .25 for 1/4th of the annual costs or merely looking at quarterly data. This number is an estimate only, like a professor grading essay papers, the difference between the grade of a B+ or A is discretionary.
Now following with a business that has a direct labor expense in cost of sales of $300,000 per year, you would multiply the twelve-month fiscal year number by 0.25; that calculates to $75,000 per quarterly 300,000 * 0.25). If your operating expenses or general and administrative expenses are $250,000 for the twelve-month fiscal year, then you would multiply that balance by 0.25 to arrive at a calculated $62,5000 ($250,000* 0.25).
The greater of those two numbers is your optimized working capital. That is the $75,000 or $62,500. The greater is the direct labor of $75,000. Do you make the grade? Your business is solidly pillared if you have the greater of these two numbers in the working capital formula, i.e., $75,000.
In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon. If you have working capital above the calculation, your business can take on additional risk to safely develop the expansion of operational activity, as long as you continue to maintain or monitor appropriate working capital levels in your business.
In the above-calculated working capital scenario, the $50,000 of working capital measurement divided by $75,000 is a 66% ($50,000 balance sheet working capital / $75,000 profit and loss measurement) Making the grade? Yes, it’s that simple.
The working capital grading tool works like this:
1. 35% equals one month of working capital
2. 70% equals two months of working capital
3. 100% equals three months of working capital.
4. You can score well above 100% in a firmly positioned business, and you’re ready for the debt Euroclydon.
If your business working capital grade is below 15% to 25%, your business likely needs immediate help from an expert financial advisor. On the other hand, the $25,000 increase required from $50,000 to achieve $75,000 can be obtained with steady additional earnings and profits retained in the business, i.e., you can earn your way out of the problem, or maybe a long-term amortization of say a line of credit, i.e., reducing current liabilities.
To be continued.