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Analyzing the working capital of a company:
One of your principal goals when managing a business is to keep your working capital as low as possible for a given level of sales, and to keep it in control when your operations are growing. Indeed, the working capital should remain proportional to the level of sales, as a rule of thumb. This is because it is a reasonable approximation to say that receivables, payables and inventories must all be roughly proportional to the level of sales.
However, this is not completely accurate since one could argue that, as your sales increase, you are producing more and thus are enjoying better payment terms from your suppliers. On the contrary, you would also face increased administrative expenses because large stocks and important cash flows cannot be managed as easily as smaller ones.
What is happening in practice ? Well, in real life, things are not as easy as they might seem on paper: when sales are growing, most of the time, its working capital is growing more than on a proportional basis, which reflects the fact that managing growth is indeed an intricate issue that you should keep in mind, because failing to do so might bring your business liquidity problems which might very well lead you to bankruptcy.
You can now guess that the ratios relevant with working capital analysis are the following ones:
- (Working Capital x 100 / Sales), expressing working capital as a percentage of sales and
looking at the variation of this ratio along the years. Very often, one also has a look at the ratio (Working Capital x 365 / Sales), which represents the “days in sales”. Concretely, this represents how many days in sales are being immobilized by your working capital.
- Days in Receivables or (Receivables x 365 / Total Sales), representing the number of days in sales immobilized by the receivables outstanding.
- Days in Payables or (Payables * 365 / Total Purchases), representing the number of days in purchases immobilized by the payables outstanding.
- Days in inventories or (Inventories * 365 / Total cost of production of these inventories), representing the number of days of production immobilized by inventories.
A careful examination of all previous three ratios will prove to be necessary in order to determine the breakdown of your working capital, explain its evolution along the years and act upon these constituents that are making it bigger (since you probably remember that your goal is to maintain a working capital as low as possible, and even negative if possible).
Addendum: evolution of working capital in a period of crisis
How does working capital typically react to a sudden change in consumption patterns (i.e. to a change in demand for your company’s products) ?
Assume demand for your products or services is dropping. By the time you realize it, your inventories will already have increased (because of all the unsold goods) and you will then try to curb production. Your amount of receivables will still remain high for a while (in a period of crisis, people tend to pay later), but your accounts payable will decrease more quickly (because suppliers will impose stricter payment conditions). Thus, your working capital will tend to remain rather high. It is only after a while that it will be able to adjust to the new production rhythm and stabilize at a lower level (which will be considered as reasonable when calculated as a percentage of sales). Once again, always pay close attention to the control of your working capital during periods of slowdown or high growth.