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Days of Working Capital
by Rusty Luhring, Fall 2006
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 business partner, 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, and have since partnered in a new venture call Franchise Analytics.
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 + DSO – 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.
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
1. What if you cut your DWC from 90 days to 60 days? If you are doing $500,000 a year in business, this would free up about $41,000 in cash. Nothing to sneeze at.
2. What if you get sloppy and your DWC climbs from 90 days to 180 days? Again, if you are doing $500,000 per year, it means you have to put up an additional $123,000 in cash.
3. What if you are trying to grow from $500,000 per year in sales to $1,000,000 per year in sales? If your DWC is a constant 60 days, it means you need another $82,000 in capital to support the higher level of sales.
(See “How to calculate DWC” at the end of this article).
4. 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 $ 1 million per year in sales, 10 days of DWC equates to about $27,400. If you can get 4% interest on excess funds, that 10 days of DWC is costing you $1,100 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 $500,000 a year in sales..
Daily Sales = $500,000 / 365, or $1,370
Working Capital at a DWC of 90 = 90 * $1,370 = $123,300
Working Capital at a DWC of 60 = 60 * $1,370 = $82,200
The difference is $41,100
2. What if you get sloppy and your DWC climbs from 90 days to 180 days? Again, if you are doing $500,000 per year..
Daily Sales = $500,000 / 365, or $1,370
Working Capital at a DWC of 90 = 90 * $1,370 = $123,300
Working Capital at a DWC of 180 = 180 * $1,370 = $246,600
The increase in working capital is $123,300
3. What if you are trying to grow from $500,000 per year in sales to $1,000,000 per year in sales? If your DWC is a constant 60 days..
Daily sales at $500k level = $500,000 / 365, or $1,370.
Working Capital at a DWC of 60 and sales of $500,000 per year = 60 * $1,370 or $82,200.
Daily sales at $1 million level = $1,000,000 / 365, or $2,740
Working Capital at a DWC of 60 and sales of $1,000,000 per year = 60 * $2,740 or $164,400.
The increase in working capital required in $82,200.
4. What if you have plenty of capital? Reducing DWC by 10 days with $1,000,000 in annual sales..
Daily sales at $1 million level = $1,000,000 / 365, or $2,740
Working Capital at a DWC of 10 and sales of $1,000,000 per year = 10 * $2,740 or $27,400.
Opportunity cost of not investing $27,400 at 4% per year is .04 * $27,400, or $1,100.
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