When a business trades is has a working capital requirement, it buys goods from suppliers, holds them as inventory, and then sells them to customers.
The amount of finance a business needed to carry out this day to day trading activity is referred to as the working capital requirement or working capital funding gap, and varies from industry to industry depending on the amount of time the business takes to pay suppliers, the amount of inventory held, and the time it takes to collect cash from customers.
Working Capital Requirement Example
The point is best illustrated by way of an example. Suppose a business buys goods for cash at a cost of 100, holds no inventory, and immediately sells the goods for 250, making the business a profit of 150. Assuming all transactions take place at the same time, the business starts off with zero cash in the bank, receives 250 from the customer, pays 100 to the supplier, and ends with 150 cash in the bank. The business did not need any additional finance to do this, its working capital requirements are zero.
Now consider what happens to the same business if it buys for cash from the supplier, holds 500 as inventory for 30 days, and sells to the customer on 60 day credit terms (meaning it has to wait for 60 days before receiving cash from the customer).
This time the business must immediately pay 500 to the supplier for the inventory which is held for 30 days. During this time, the business which started with zero in the bank account, has had to find the finance (e.g. overdraft or loan) to fund the inventory, its working capital requirement is 500.
After 30 days it sells goods costing 100 to a customer from 250, its inventory falls to 400, but now it must wait 60 days to receive the 250 from the customer, during this period of time, its working capital requirement is the inventory 400, and the amount due from the customer (accounts receivable) of 250, a total of 650.
In the above example we assumed that the business had to pay cash to its suppliers. However, if the supplier gave 45 day credit terms, for the first 45 days the business would not have to pay for the goods held in its inventory and its working capital requirements would fall by the amount due to the supplier (accounts payable).
Working Capital Requirement Formula
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 below:
This requirement to find the finance to fund inventory and accounts receivable is an issue for any business, but can be a major cause of concern for a high growth start up business. As the business grows rapidly, its sales increase, which in turn increases the accounts receivables due from customers and the amount of inventory it needs to hold. This rapid increase in working capital requirement can cause a business to run out of cash unless it has adequate finance in place to deal with the issue. This a particular cause for concern in start ups who tend by their nature not to have access to large amounts of finance nor the ability to obtain credit from suppliers.
Forecasting Working Capital Requirements
At any point in time a business needs to be able to estimate its working capital requirement. As the revenue figure is normally to 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. Dealing with each component of the working capital requirement in turn;
Suppose revenue is estimated to be 182,500 for the year and the business offers 45 day credit terms to its customers. The working capital requirement to fund accounts receivable is given as follows:
Accounts receivable = Days credit x Daily revenue Accounts receivable = 45 x 182,500 / 365 Accounts receivable = 22,500 Accounts receivable % = 22,500 / 182,500 = 12.3%
On average, at any one time, the working capital requirement resulting from offering credit to customers will be 22,500 or 12.3% of revenue.
Clearly this figure will increase rapidly as either the revenue, the days credit given to customers or both increases. Consider what happens if through poor collection procedures the credit period given increases to 90 days. By substituting 90 days instead of 45 days in the formula used above, the working capital requirement doubles to 45,000 or 24.7% of revenue. If the poor collection procedures cause the working capital requirement to increase beyond the available facilities then the business will simply run out of cash.
A similar calculation can be carried out to find the working capital requirement for inventory. Suppose the business holds 30 days inventory. As inventory is carried at cost we need to base the calculation of inventory levels on the cost of sales. The cost of sales can be found using the following formula:
If for example, the gross margin percentage of the business is 40% then our inventory calculation looks like this.
Inventory = Days inventory x Daily cost of sales Inventory = Days inventory x Daily revenue x (1 - Gross margin %) Inventory = 30 x (182,500 / 365) x (1 - 40%) Inventory = 9,000 Inventory % = 9,000 / 182,500 = 4.9%
The inventory working capital requirement is 9,000 or 4.9% of revenue. Again, any lack of control, letting inventory levels rise, can cause severe cash flow problems. For example, if the inventory levels rose to 120 days (4 months inventory), the working capital requirement increases to 36,000 or 19.7% of revenue.
Of course as we have seen above, the need for working capital to fund inventory and accounts receivable, can be reduced by increasing the credit terms with suppliers (accounts payable). As the payments to suppliers are at cost, we can use a similar procedure and calculation to that used for inventory.
Suppose we are given 20 days credit by the supplier, and again the gross margin percentage is 40%, the working capital requirement reduction as a result of supplier credit terms is calculated as follows:
Accounts payable = Days credit x Daily cost of sales Accounts payable = Days credit x Daily revenue x (1 - Gross margin %) Accounts payable = 20 x (182,500 / 365) x (1 - 40%) Accounts payable = 6,000 Accounts payable % = 6,000 / 182,500 = 3.3%
The accounts payable working capital reduction is 6,000 or 3.3% of revenue. It is better where possible to negotiate better terms with suppliers rather than increase supplier credit terms by delaying payment, as sooner or later the overdue accounts will lead to supply problems.
Net Working Capital Requirement
We can combine the accounts receivable, inventory, and accounts payable working capital requirements to give the net working capital requirement.
This is summarized for our example, in the table below:
|Gross working capital requirement||31,500||17.2%|
|Net working capital requirement||25,500||13.9%|
Based on this information, the net working capital requirement is 13.9% of revenue. 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. Suppose for example, the business is offered a new contract worth 40,000 in revenue, it can now estimate that if the contact is accepted, it will most likely need an additional 40,000 x 13.9% = 6,000 of finance to deal with the increased business.
What Happens When the Terms are Extended?
If for example, the business allowed the credit given to customers to extend to 90 days and the inventory levels to increase to 120 days, without any increase in credit from suppliers, the situation would look completely different.
|Gross working capital requirement||81,000||44.4%|
|Net working capital requirement||75,000||41.1%|
This time, if the business was to consider the new contract of 40,000, it would need a substantial increase in additional finance to fund the working capital requirement of 40,000 x 41.1% = 16,440.
Working Capital in the Financial Projections Template
The financial projections template uses these calculations based on revenue, cost of sales and days to work out the accounts receivable, inventory, and accounts payable shown in the balance sheet, this in turn leads to the change in working capital shown in the cash flow statement of the business.
By amending the days sales outstanding, inventory days, and days payable outstanding, it is possible to change the working capital requirements of the business and see the impact of this on the cash flow statement.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.