About the author.
Susie Kevern, FCMA, is a management accountant providing services to SMEs in the area of interpreting, evaluating, and planning financial performance of the business, and advising on strategic decisions to business owners, and management boards.
She graduated in Physics, and Meteorology, at the University of Reading, in 1999, and qualified as a Certified Management Accountant (CIMA) in 2004.
She can be contacted via her website Poundlane Business Services.
Managing working capital.
In an earlier chapter we looked at how to calculate the Working Capital of our business. While the Profit and Loss account tells us whether a business is profitable, it doesn't tell us whether we can pay our bills. Working capital is the lifeblood of any business operation.
Working capital is the difference between current assets and current liabilities. In simple terms:
- Current Assets: Cash, receivables (money owed to us), inventory
- Current Liabilities: Payables (money we owe), short-term debts
Formula:
Working Capital = Current Assets - Current Liabilities
A profitable business can still fail if it runs out of cash. Understanding working capital helps managers answer critical questions:
- Can we pay our suppliers on time?
- Do we have enough cash to cover next month's wages?-
- Are we holding too much inventory?
The Three Components
The cash conversion cycle measures how long it takes to convert investments in inventory and receivables back into cash.
- Stock Days
- How long inventory sits before being sold
- Formula:
(Average Inventory / Cost of Sales) × 365
- Debtor Days
- How long it takes customers to pay us
- Formula:
(Average Receivables / Total Sales) × 365
- Creditor Days
- How long we take to pay suppliers
- Formula:
(Average Payables / Cost of Sales) × 365
Cash Conversion Cycle = Stock days + Debtor Days – Creditor Days
A shorter cycle means cash returns to the business faster.
Working Capital Ratios - Your Yardstick Measures
Following the approach from the P&L analysis chapter, we can add some additional working capital components as percentages and ratios:
Working Capital as % of Sales
Formula: (Working Capital / Total Sales) × 100
- Track this percentage over time
- Rising percentage may indicate inefficiency
- Compare quarter-to-quarter like the P&L analysis
Inventory Turnover Ratio
Formula: Cost of Sales / Average Inventory
- Higher ratio = faster inventory movement
- Industry-dependent (grocery stores vs. car dealers)
Practical Example: The Forecourt Business
Building on the petrol forecourt example from the P&L chapter, let's add some details regarding its working capital:
| Metric | Q1 | Q2 | Change |
|---|---|---|---|
| Current Ratio | 1.8 | 1.5 | -0.3 |
| Quick Ratio | 1.2 | 0.9 | -0.3 |
| Working Capital | £45,000 | £38,000 | -£7,000 |
| WC as a % Sales | 11% | 9% | -2% |
| Stock Days | 18 days | 22 days | +4 days |
| Debtor Days | 12 days | 15 days | +3 days |
| Creditor Days | 25 days | 28 days | +3 days |
| Cash Conversion Cycle | 5 days | 9 days | +4 days |
What This Tells Us
- Liquidity is declining - Both current and quick ratios have dropped
- Inventory is moving slower - Stock sitting 4 days longer
- Customers paying slower – Customers taking 3 extra days to pay
- We're delaying payments - Taking advantage of supplier credit
- The cash cycle is lengthening - Money tied up longer in operations
Action Points to consider
- Review slow-moving inventory lines
- Tighten credit terms or follow up on overdue accounts
- Consider early payment discounts from suppliers if cash allows
Summary
Working capital management isn't optional - it's essential. By tracking these ratios and metrics over time, just as we do with P&L percentages, managers gain a powerful "yardstick" for financial health. The key is consistency: measure regularly, compare over time, and act on what the numbers reveal.
Remember: Profit is an opinion, but cash is a fact.