Small Business Taxes & Management^TM--Copyright 2015, A/N Group, Inc.

In Working Capital--It's Not Just a Term we discussed the basics of working capital. In this article we'll take the discussion a few steps further. Throughout this article we're talking about net working capital, that is, current assets less current liabilities. Go to the earlier article to see the definition of current assets and current liabilities.

In the previous article we talked about the importance of working capital to the business. Outside lenders and other creditors are also keenly interested. It's an important measure of how you're able to pay your current bills. Negative working capital means you've got a liquidity problem. Sometimes there's an explanation, such as paying cash for an expensive piece of equipment, but even if the problem is temporary you don't want to explain that to a bank officer. Having little or no working capital can also be an indication of poor financial management.

Having little or no working capital is also one of the prime reasons many small- to mid-sized businesses fail. It does you no good to be sitting on $3 million of real estate and equipment with only $1 million in long-term debt if you don't have working capital to pay salaries, bills, etc. Selling assets is rarely an option and getting financing is often difficult, especially if you're already short of working capital.

How Much do You Need?

There's no rule of thumb here, but there are at least three factors to consider. First, the absolute amount of working capital. A business with $100,000 of current assets and $60,000 of current liabilities would have $40,000 of working capital. So would a business with $500,000 in current assets and $460,000 of current liabilities. But there's no question that the first business has a much higher safety margin than the second. There's a way to handle this situation which we'll discuss below.

Second, much depends on the risk inherent in the business. A business with a steady, even cash flow often needs less working capital. For example, a convenience mart gets steady, predictable business, inventory turnover is generally quick and accounts receivable are in the form of credit card receivables that will be paid at a specific time.

The third factor is the makeup of current assets and liabilities. A business where current assets consist largely of cash and accounts receivable is generally in a better position than one where the current assets consists largely of inventory. Collection of accounts receivable is more predictable than the conversion of inventory to cash or accounts receivable and takes longer. Inventories are less valuable if they go bad or obsolete if not sold by a certain date. The value of prepaid expenses in the computation of working capital is even less significant. Fortunately, that's rarely a substantial component.

Other factors that can affect your working capital is seasonality. Some businesses tend to accumulate cash after the busy season along with low levels of receivables, inventories, and payables, only to have the situation reverse at other times.

Service businesses need positive working capital, but managing it is often much easier since liabilities usually consist primarily of accrued salaries (and possibly the current portion of long-term debt) and current assets are usually cash and receivables.

Clearly, the more cash, the better, but cash generally provides little or no return. So, in theory, you want to hold cash only to fill in the slack. For example, in an idealized world inventory would be sold converted to accounts receivable and then to cash which would immediately be used to pay suppliers for the inventory. There are businesses that can sell inventory so fast and convert it to cash before they have to pay their supplier, but there aren't many.

Unfortunately, because lenders and suppliers often put much weight on the measure of net working capital, if you have outsiders looking at your financials, you've got to be sure you satisfy their requirements, even if you have to carry extra cash.

How do you use net working capital to monitor your financial status? First, you should be showing positive amounts for net working capital. As discussed, how much depends on your business and the makeup of your current assets. And, more importantly, you want to monitor your working capital from period to period, preferably at least quarterly.

Current Ratio

Perhaps a better measure of liquidity is the current ratio. It takes into account the size of current assets and liabilities. The ratio is no more complicated than computing net working capital:

    Current Ratio = Current Assets/Current Liabilities

The current ratio allows you to make longer-term period to period comparisons--a 1.5 to 1 coverage is just as meaningful if current assets and current liabilities grow over time. A second advantage is that you can compare your firm's results to others in the industry or the industry norm. Of course no two firms are identical so such comparisons should be made cautiously. Even period-to-period comparisons in the same firm should be analyzed. The ratio may be abnormally high because you just sold a large piece of equipment and are holding cash. The reverse could also be true, cash was just used to purchase equipment.

Despite some advantages, the current ratio suffers the same deficiency of any balance sheet measure--it's only a snapshot of your position at the moment. What we'd like to know is will the firm's cash flow inflow be sufficient to meet the outflow requirements. The only real way to answer that question is with a detailed cash forecast. Again, many lenders look at your current ratio as a measure of liquidity, and their opinion is important.

Acid-Test Ratio

Also known as the quick ratio, the idea is the same as the current ratio but current assets are limited to cash and cash equivalents and accounts receivable. Current liabilities are unchanged. The logic for eliminating inventories is they are harder to measure (that may not be as true today because of the use of computerized inventory) and to value. The acid-test ratio does put more stress on the business. For service businesses the differences might be immaterial.

Observations

Many companies engage in quarter-end "window dressing" to make the balance sheet look better to outsiders. Making an extra effort to book sales to increase accounts receivable or cash. While lenders will see a better ratio or net working capital, the result is just temporary unless you aggressively speed up collections.

There are some steps you can take on a long-term basis to increase working capital and show a better quick ratio. Perhaps the easiest, and smartest, is to finance long-term assets with long-term money. For example, if you want to conserve working capital and have an attractive quick ratio use a loan for vehicle purchases rather than cash, even if you have it. Both the vehicle and the loan (except for the current portion) will show up in the long-term section of your balance sheet.

Distributions from a partnership, S corporation, LLC, etc. invariably use cash. For most small businesses taking distributions is akin to a salary. Take what you need to live on, but don't take funds just because they're there. Some owners take the money out because they're afraid they won't have a chance if the company is sued, has financial problems, etc. There are a number of reasons why that's generally bad logic.

Be aggressive when it comes to accounts receivable. If you can collect your accounts receivable quicker you can have a larger amount outstanding (increasing current assets) without increasing short-term loans or other credit to finance them. Alternatively, the faster recovery can increase your cash position or allow you to pay down liabilities.

The same logic works for inventories. If you can increase sales with the same level of inventories you'll generate more cash.

You may be able to fund inventories and accounts receivable with longer term loans or equity capital. This approach should be used with caution since there are risks involved.

Careful timing of infrequent payments, such as annual bonuses, can make a particular quarter look better than it would normally.

As always, talk to your accountant for suggestions particular to your business.

--Last Update 06/10/15