How to Calculate the Working Capital Requirement (WCR) ?
WCR = [Accounts Receivable + Inventory + Prepaid Expenses]
minus
[Accounts Payable + Accruals]
Example :
Click here to see the source of data Starworld Group End of Year
Year 1 Year 2 Year 3
Accounts Receivable 232 278 362
Inventory 97 116 151
Prepaid expenses 35 20 55
Total 364 414 568
Accounts Payable 116 139 181
Accruals 36 45 55
Total 152 184 236
WCR (*) + 212 + 230 + 332
+
(*) As the WCR is positive, that means a Net Requirement of funds.
Variation of WCR :Starworld Group Year 2 Year 3
Accounts Receivable 46 84
Inventory 19 35
Prepaid expenses -15 35
Total 50 154
Accounts Payable 23 42
Accruals 9 10
Total 32 52
Variation of WCR (*) + 18 + 102
(*) As the variation of WCR is positive, that means a Net Requirement of funds : 18 in 2000 and 102 in 2001. 2008 2009
sources uses Sources Uses
Accounts Receivable - 46 - 84
Inventory - 19 - 35
Prepaid expenses 15 - - 35
Accounts Payable 23 - 42 -
Accruals 9 - 10 -
47 65 52 154
Net Requirement of Funds - 18 - 102
Estimating working capital needs is critical when starting up a new business, and when going through a period of growth and expansion. By understanding the cycles a business goes through, and assigning some numbers to them, it is possible to come up with a realistic estimate of how much working capital you should have on hand. And, when a business is experiencing financial difficulties, an analysis of these cycles and the impact they have on cash flow and resources enables taking the necessary steps to turn the situation around.
Working Capital Cycle and Cash Conversion Cycle
A production environment, whether large or small, may serve as a good example for defining the different stages a business operation goes through, from the time commitments are made for raw materials, supplies, and services, until payment is received from the customer for the final product sold.
Working capital includes inventory, payables, and receivables, so the working capital cycle covers the period from when commitments are first made until payment is received from the customer. The working capital cycle may differ from the cash conversion cycle, since goods and services may be purchased on credit; certain expenses such as salaries, wages, and utilities accrue during the period; and sales to the customer may be on credit terms. So, the cash conversion cycle is the time from payment of accruals to collection of receivables. It is the amount of time cash is tied up in the cycle, and not available for other purposes.
Throughout the process, incremental costs will continue to be added and will need to be financed with working capital until payment is received and the cycle is complete. For example, at the start of the production period the costs are in raw materials. As production begins, costs for labor, supplies, and overhead are added. When finished goods are placed in inventory, storage costs may be incurred. And the sale of the products to customers may involve shipping costs, commissions, or other selling expenses. Working capital requirements increase as the business cycle progresses.
Ongoing Cycles
Another point to take into consideration is that cycles are ongoing. Purchases and collections may be made every day during the period, so the cycle for one particular product overlaps with the cycle for another product. The cycle is constantly repeating itself, and at any given point in time, each individual cycle will be at a different stage of completion. The idea is to come up with a way to determine average balances for inventory, payables and receivables in order to determine an overall estimate of working capital needs.
Breaking Down the Cycle
The entire process starts with the receipt of raw materials. If they are purchased on credit, there is a commitment, in terms of accounts payable, but a cash disbursement has not yet been made. So in effect, the time from when a purchase commitment is made until the time the supplier is paid is really financing that the business is gaining, and serves to reduce the need for other sources of financing.
If production is not started immediately, there will be a period of time when raw materials are in inventory. Once production starts, the raw materials will enter the next phase - the work-in-process inventory, where additional costs such as labor and utilities will be added. The work-in process period ends when the products are completed and the production cycle ends with the finished goods inventory.
It may turn out that products are not sold immediately upon completion, so there is a period when finished products remain in inventory pending their sale. And when sales are made, there may be a delivery period involved, and the sales may be on credit terms, so the process enters the final period in which accounts receivable are pending payment. Once collection is made and payment is received from the customer, the cycle is complete.
So, the overall business cycle can be broken down as follows:
Number of days raw materials are in inventory
Minus number of days of accounts payable to suppliers
Plus number of days in work-in-process
Plus number of days products are in finished goods inventory
Plus collection period from customers
Equals cash conversion period.
Once these periods are defined, calculations can be made to begin to develop an estimate of working capital needs.
Calculating Periods
In order to calculate the number of days involved in each part of the process, some estimates may have to be made. The date may be available and it may need to be updated occasionally, in order to obtain a more realistic result. Or it may simply need to be estimated. The following formulas will indicate the figures that are needed.
The average number of days raw materials are in inventory can be calculated as:
Average raw materials inventory / Average annual purchases x 365 = Days of raw materials inventory
Average days in work-in-process are calculated as:
Average balance of work-in-process inventory / Average annual cost of production x 365 = Days of work-in-process inventory
Average days of finished goods inventory are:
Average balance of finished goods inventory / Average annual cost of sales x 365 = Days of finished goods inventory
Terms with Suppliers and Customers
The other periods involved in the cycle are the average payment terms with suppliers for purchases of materials, the average payment period for other expenses, and the average credit terms with customers for sales. With this information, the first stage of calculating working capital needs based on days of sales to finance is complete. The next stage involves assigning values to these periods.
Number of Days
Based on the above calculations, an example could be generated, as follows:
Days of raw materials inventory = 5
Days of work-in-process inventory = 15
Days of finished goods inventory = 10
Payment terms with suppliers = 30
Payment terms for other expenses = 10
Credit terms with customers = 45
This information may be available from historical records on production, or based on personal experience in the business. Or it may be based on contractual terms, such as payment terms with suppliers and credit terms with customers.
Percentage Components of Sales Price
The next step is to express the final sales price of the product in terms of its component parts; that is, what part of the sales price is represented by raw materials and other expenses. If it is assumed for purposes of this example that raw materials represent 20% of the final sales price and other expenses represent 50%, these percentages can then be applied to the number of days involved in each stage of the cycle, as previously determined, to calculate the number of days of sales that need to be financed. For purposes of the example, it is assumed that work-in-process contains both the 20% component for raw materials and the 50% component for other expenses. In practice, the costs invested in work-in-process depend on the stage of completion of the products in inventory. It may be necessary to refine this aspect, based on the particular business and the level of information available.
Calculating Days Based on Percentage Components
Based on the foregoing information, the number of days involved in each separate period of the process times their corresponding percentage component of the sale price are as follows:
Raw materials: 5 days x 20% = 1 day
Work-in-process: 15 days x 70% = 10.5 days
Finished goods: 10 days x 70% = 7 days
Suppliers: 30 days x 20% = 6 days (this number is subtracted)
Other expenses: 10 days x 50% = 5 days
Customers: 45 days x 70% = 31.5 days
Equals total number of days of sales to finance: 49 days
Calculating Days of Sales to Finance
The next step is to take the total estimated annual sales and express them in terms of sales per day. For example:
Total annual sales of RS500,000 / 365 days = RS1,370 per day
The number of days of sales to finance (49 days) times sales of RS1,370 per day equals an estimated working capital requirement of RS67,130.
The above example outlines the general steps involved in estimating working capital requirements using this methodology, and by refining the date a closer approximation can be obtained.
=========================
How to Calculate Working Capital
Step
1
Begin by determining current assets. Current assets are comprised of cash, marketable securities, accounts receivable and current inventory. Sum the total value of each of the above to arrive at the current assets
Step
2
Determine current liabilities. Current liabilities include accounts payable, accrued expenses, notes payable and the portion of long-term debt that is classified as current. Sum all of these accounts to arrive at the current liabilities figure.
Step
3
Take the total of the current assets and subtract them from the current assets. The result will be the working capital. In other words, current assets minus current liabilities equals working capital.
Step
4
Look at the following example: The company has RS100,000 in cash, RS50,000 in securities, RS10,000 in account receivable, and RS30,000 in inventory. On the current liabilities side, the company has RS60,000 in accounts payable, RS10,000 in accrued expenses, and RS20,000 in current debt. The current assets are RS100, 000 + RS50,000 + RS10,000 + RS30,000 or RS190,000.The current liabilities are RS60,000 + RS10,000 + RS20,000 or RS90,000.Take the current assets of RS190,000 and subtract the current liabilities of RS90,000 to arrive at the working capital of RS100,000.RS190,000 - RS90,000 = RS100,000.
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Days of Working Capital
by Rusty Luhring
If you had to settle on one measure to monitor your company’s need for capital, this would have to be it. The lower the figure, the less capital you need to grow. The less capital you need to survive. Capital in a small business is not easy to come by, so it is worth spending a little time to keep on top of this critical measure.
Background
A few days ago, I got an email from my friend, Philip Campbell:
“Rusty, attached is an interesting look at some working capital KPIs from CFO magazine."
Philip, as many of you know, is the author of one of my favorite business books, Never Run Out of Cash. A few years ago, we struck up a friendship on the basis of our mutual interest in small company cash flow.
So instead of hitting the delete button, I took a look at what he sent.
The working capital KPIs (Key Performance Indicators) included the standard three that I use in financial models routinely:
DSO – Days Sales Outstanding in Accounts Receivable
DSI – Day Sales Outstanding in Inventory
DPO – Days Sales Outstanding in Accounts Payable
The fourth was DWC or Days of Working Capital. This is simply DSO + DSI – DPO, or a way of expressing how much cash is tied up in Accounts Receivable and Inventory less the trade credit extended to you via Accounts Payable. Expressing it in terms of “Days of Sales” is a way making it comparable from one company to the next. Or making it comparable within a company over time as sales grow or decline.
The Hackett Group – REL had collected the data on a number of public companies, and summarized the data by industry sector. They reported that U.S. public companies had reduced working capital by 5.6% in 2005, and 3.6% in 2004. These reductions were considered to be A GOOD THING.
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A couple of examples:
The auto industry (GM and Ford) had DWC of 260.3 days at the end of 2005.
Southwest Airlines had -5.6 days.
Dell Computer had -24.9 days. It does this by keeping receivables fairly low (35.6 days), almost no inventory (3.8 days), and forcing suppliers to wait for their money (64.2 days in Payables).
(see www.thehackettgroup.com/research/tw and click on “Read CFO.Com article” to get a copy of the report)
What does this measure - Days of Working Capital - mean?
Let’s look at the three main components of working capital:
Accounts Receivable
Inventory
Accounts Payable
Accounts Receivable and Inventory are both Current Assets, and in effect tie up cash that could be used for other purposes.
Accounts Payable is a Current Liability, and consists of trade credit extended to you by your vendors.
If your only goal is to minimize the use of working capital, then you do everything you can to keep Accounts Receivable and Inventory low, and Accounts Payable high. But you have to temper this with business reality:
Extending credit to customers (Accounts Receivable) may be important in order to get the business.
If you don’t have it in Inventory, you can’t sell it (at least if you are a bricks and mortar retailer).
If you take too much time paying vendors, they may not want to do business with you, or may not offer you good prices.
So this is a balancing act, and you have to make judgments. (This is why you get paid the big bucks!)
The questions become:
How can I reduce the level of Accounts Receivable without adversely impacting sales? Maybe it is a matter of culling out the deadbeats, or offering discounts for quick payment. Or simply having your bookkeeper call late accounts systematically.
How can I keep the bare minimum in inventory without losing sales? This may involve an investment in technology, or finding vendors who can guarantee short lead times.
How can I make the best use of trade credit without upsetting key vendor relationships? Part of it is being selective. You may want to take care of the little guys who run close to the edge more quickly than the others. It is amazing the impact that can have on service and going the extra mile on your behalf. Part of it may be negotiation – “we’ll buy more from you if you extend the terms to 45 days from 30 days.”
The Impact of DWC in a small business
What if you cut your DWC from 90 days to 60 days? If you are doing RS500,000 a year in business, this would free up about RS41,000 in cash. Nothing to sneeze at.
What if you get sloppy and your DWC climbs from 90 days to 180 days? Again, if you are doing RS500,000 per year, it means you have to put up an additional RS123,000 in cash.
What if you are trying to grow from RS500,000 per year in sales to RS1,000,000 per year in sales? If your DWC is a constant 60 days, it means you need another RS82,000 in capital to support the higher level of sales. (See “How to calculate DWC” at the end of this article).
What if you have plenty of capital?
Then it is a cost issue. Maybe it isn’t critical to squeeze out 10 days of DWC. But just be aware of what those 10 days are costing you. If you do RS 1 million per year in sales, 10 days of DWC equates to about RS27,400. If you can get 4% interest on excess funds, that 10 days of DWC is costing you RS1,100 per year in pretax profit.
Appendix – How to calculate DWC
Remember the definitions:
DSO – Days Sales Outstanding in Accounts Receivable
DSI – Day Sales Outstanding in Inventory
DPO – Days Sales Outstanding in Accounts Payable
DWC = DSO + DSI – DPO
DSO – Days Sales Outstanding in Accounts Receivable
Thus, DSO for any given period is the Accounts Receivable balance divided by Daily Sales.
If you are a billion dollar company, you can just use last year’s results. Take annual sales divided by 365 to get Daily Sales. Divide the end of year Accounts Receivable by Daily Sales to get DSO.
Some of us have not reached that level yet, and in the interest of being nimble, would like to calculate and monitor these KPIs on a monthly basis. What I like to do is calculate a three month moving average Sales and divide this by 90 to get the Daily Sales as of each month. Then divide the end of month Accounts Receivable by this Daily Sales figure to get DSO.
DSI – Day Sales Outstanding in Inventory
DSI for any given period is the Inventory balance divided by Daily Sales. Calculate the monthly DSI just like you would the DSO by taking a 3 month moving average sales figure divided by 90 to calculate daily sales.
NOTE: DSI is a component of the DWC calculation, and is NOT the same as Days of Inventory on hand. Days of Inventory is a measure of how many days you have before you run out of inventory if you do not replenish. It is calculated by taking the Inventory balance and dividing by the Daily Cost of Sales (not Daily Sales).
DPO – Days Sales Outstanding in Accounts Payable
DPO for any given period is the Accounts Payable balance divided by Daily Sales. Calculate the monthly DPO just like you would the DSO by taking a 3 month moving average sales figure divided by 90 to calculate daily sales.
NOTE: DPO is a component of the DWC calculation and is NOT the same as what is commonly referred to as Payable Days. Payable Days is a measure of how long it takes for you to pay your bills, and is best calculated as the Accounts Payable balance divided by Daily A/P Related Expenses. A/P Related Expenses include most operating expenses but exclude Salaries and Wages, Depreciation, and other expenses not run through Accounts Payable.
Calculating capital requirements based on DWC
Once you have a DWC figure, you can calculate Working Capital by multiplying DWC by Daily Sales.
To answer the what if questions earlier in this article:
1. What if you cut your DWC from 90 days to 60 days? If you are doing RS500,000 a year in sales..
Daily Sales = RS500,000 / 365, or RS1,370
Working Capital at a DWC of 90 = 90 * RS1,370 = RS123,300
Working Capital at a DWC of 60 = 60 * RS1,370 = RS82,200
The difference is RS41,100
2. What if you get sloppy and your DWC climbs from 90 days to 180 days? Again, if you are doing RS500,000 per year..
Daily Sales = RS500,000 / 365, or RS1,370
Working Capital at a DWC of 90 = 90 * RS1,370 = RS123,300
Working Capital at a DWC of 180 = 180 * RS1,370 = RS246,600
The increase in working capital is RS123,300
3. What if you are trying to grow from RS500,000 per year in sales to RS1,000,000 per year in sales? If your DWC is a constant 60 days..
Daily sales at RS500k level = RS500,000 / 365, or RS1,370.
Working Capital at a DWC of 60 and sales of RS500,000 per year = 60 * RS1,370 or RS82,200.
Daily sales at RS1 million level = RS1,000,000 / 365, or RS2,740
Working Capital at a DWC of 60 and sales of RS1,000,000 per year = 60 * RS2,740 or RS164,400.
The increase in working capital required in RS82,200.
4. What if you have plenty of capital? Reducing DWC by 10 days with RS1,000,000 in annual sales..
Daily sales at RS1 million level = RS1,000,000 / 365, or RS2,740
Working Capital at a DWC of 10 and sales of RS1,000,000 per year = 10 * RS2,740 or RS27,400.
Opportunity cost of not investing RS27,400 at 4% per year is .04 * RS27,400, or RS1,100.
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