Todays six geese a laying challenge is to calculate how much working capital your business consumes for every £1 of sales.
Working capital comprises the amount a business needs to invest in stock and debtors to finance its sales before it gets paid.
The investment is reduced by the amount of creditors who are financing part of the working capital requirement until they are paid.
So, the formula for working capital is: Stock + Debtors – Creditors, which obviously fluctuates daily as stock is purchased, sales are made and cash is collected and paid.
It is useful, therefore, to have a rule of thumb for assessing how much working capital is needed to finance stock and debtors.
Using your annual turnover, you can work out the amount of working capital your business needs. If the business is growing this is an essential metric to know and one, I find, that is almost always greater than business owners expect.
Some business owners may think that the best way to improve cash flow is to increase sales, but this overlooks the fact that cash may need to be invested before it is collected from the additional sales.
This is the reason why working capital is often financed by borrowing; if this is the case in your business then it’s important to understand exactly how much working capital you will need, as if your borrowing, for example, is too low, the business may run out of cash before its customer debts are collected.
Here’s how to calculate your working capital requirement:
Suppose your sales are £10,000 per month (£120,000 per year). If customers take 60 days to pay your debtors will be £24,000 (2 x £10,000 plus VAT at 20%) which is 20% of sales (£24,000/£120,000) expressed as a percentage.
Next there is stock to consider. This will vary depending on if you hold raw materials and work-in-progress as well as finished stock for sale, but if the raw material content of sales is 40% and total cost of sales is 70% (leaving a 30% gross margin), then the raw material percentage will be 5% and both work in progress and finished goods 7%, making at total of 19%.
So, stock and debtors combined require financing of 39% of annual sales; assuming the one mitigating factor – creditors – means that you can get 90 days credit on raw material purchases which amounts to 12% of annual sales, your total working capital requirement will be 27% of annual sales, a whopping £270,000 on sales of £1 million per annum.
Your six geese a laying challenge is to work out your working capital requirement as a percentage of sales. Start by taking the figures from your latest annual accounts for sales, debtors, stock and creditors and calculate the percentages of debtors to sales, and stock and creditors to cost of sales.
Now, using these percentages use the formula Stock + Debtors – Creditors to calculate the overall percentage.
In some businesses working capital is negative. Do you know why? If so, drop me a line by email and let me know.