WORKING CAPITAL TURN OVER
© December 2011 – By- Joel Johnson
If you are self-employed or you manage a business for someone who is self-employed, you are involved in selling products, services or both. It makes no difference if your business is a sole proprietorship, C-Corp, Sub Chapter S-Corp, LLC, LLP, or LP, your business requires working capital in some form―preferably cash.
Working capital, as you know, is your current assets (cash-on-hand, accounts receivable, inventory, and other current assets that could be converted to cash in less than one year) minus current liabilities (the sume of all money owed and due within one year). A good rule of thumb is to maintain a current ratio of at least 1.5 to 1 or better to meet your current liabilities. Banks prefer the acid test. The formula is:
total current assets, minus inventory/divided by total current liabilities.
The reason for deducting inventory value is, in most cases, inventory is not as liquid as cash and current account receivables and may not be turned into cash quick enough to service debt, should business experience hard times. In addition, should the business fail, inventory would most likely be disposed of for pennies on the dollar, making it difficult for the bank to recover its losses. It is important to maintain a good acid ratio for your own safety. If you have bank debt, the lender is watching this ratio closely.
If you sell services and do not manage inventory, your working capital consists of cash-on-hand and accounts receivable (assuming you finance some accounts for short periods of time).
It is obvious that when you have a large inventory, your cash-on-hand as a percentage of total assets is reduced, because your dollars are tied up in the products you sell and accounts receivable. When you purchase inventory, you swap dollars for things to resell to your customers and hopefully, when sales are made those dollars are recouped (unless sold at a loss) and cash again increases.
If net profits were realized on the sale of the products or services additional dollars are added to cash. That, of course, is a good thing and the main reason businesses exist. When losses occur, as you know, available working capital reduces.
When the economy slows, as has been the case for the past few years, accounts receivable becomes more difficult to collect, sometime forcing a percentage of accounts receivable to be written off. Naturally, if a reduction of working capital continues for a period of time the business may run out of working capital and will eventually go out of business.
If you manage inventory, inventory turn is vitally important. That is to say, the number of times you sell 100% of your inventory equals your inventory turn rate. The more times you are able to turn your inventory, the more cash you will generate. CASH IS KING.
EXAMPLE:
Let’s assume that you buy a product for $1.00 and you sell that product for $2.00. $2.00-$1.00 cog = $1.00 Gross Profit or 50% of the retail price. When your customer gave you his/her $2.00 you recouped your original $1.00 inventory investment. What would be the smart thing to do? Naturally, you would want to reinvest that recouped $1.00 in new inventory and sell out again. You now have turned your inventory 2 times and created $4.00 in retail sales with a $1.00 investment. Not bad! In addition, you have earned $2.00 in gross profit and you still have on hand the original $1.00 that you invested in inventory. WOW!
What would be the smart thing to do? Yes! Reinvest your $1.00 working capital and let it repeat this success. Anyway, you get the picture. The more times you can do this the stronger your cash flow will be. Let’s say you could turn your inventory five times in one year. That would create sales of $10.00 on a $1.00 investment. Hmmmm! Nine dollars in gross profit generated with a $1.00 investment. That is worth looking into. Wouldn’t you think?
To determine your inventory turn rate use the following formula:
Cost of good sold (Income Statement) $5.00 = 5.0 times
Average inventory (Balance Sheet-Beginning Inv. & End Inv.) $1.00 + $1.00/2=$1.00
Naturally, a balanced inventory investment is very important. Too little inventory creates lost sales. Too large of an investment in inventory creates a lower turn rate and reduced cash flow. Study the ebb and flow of your business so you will know when to peak your inventory and when reduce it. The important thing to do is to maximize your inventory turn rate, while maintaining healthy margins.
To determine the number of days sales in inventory use the following formula:
Average inventory (Balance Sheet-Beginning Inv + End Inv./2) $1.00 + $1.00/2=$1.00
Average daily cost of sales (Income Statement- Tot. COG/360) $5.00/360=0.01389 = 71.94 days
Let’s assume your total sales for the year is $1,000,000 (100%) and your cost-of-good sold is $500,000 (50% of sales), your gross profit is $500,000 (50% of sales), your operating expenses equal $400,000 (40% of sales) and your net profit on total sales for the full year is $100,000 (10% of sales). If your average inventory investment is $100,000 (5 times turn X $100,000=$500,000 total cog) and you’ve earned $100,000 net profit on that investment, you have earned an amount equal to 100% of your inventory investment. If you invest 25% more in inventory, thinking more is better, and you end up with the same amount of sales ($1,000,000) you will have decreased you turn rate to a 4 times turn rate and you would have decreased your return on investment by 20%. In other words, you would decrease your cash flow by $20,000.
VENDOR DEALS
Vendors are notorious (throughout the supply chain, no matter the business category) for buying shelf space. Vendors know if they can load your inventory with their product, you will have less money to buy the competitors brands. They also know that if they can load your inventory with their products, you will spend sleepless nights trying to figure out how to get it sold. This plays havoc on balanced brand inventory plans. Vendors do this by offering volume discounts, which have been loaded into their costs. Remember, they too must achieve their sales, gross profit, annual turn rates and net profit goals. If you look close enough, you will discover smoke and mirrors.
You’ve heard he pitch: “If you give us an end cap and buy a minimum of X number of cases, we will give you a discount of $2.00 per case, an amount equal to 20% of your total purchase, but you need to make your decision today. We only have limited quantities and a short window to offer this “deal.”
You think to yourself, “With this deal, I can reduce my prices and beat my competition.” Of course, your vendor has offered your competition the same deal and what do you suppose they are thinking?
So who wins this game? The vendor wins, of course. The discounts are loaded into his margins. If you buy into these “deals” you must realize that you have just increased your vendor’s bank account and reduced yours.
Note: When you personally go to a store and buy a product for $25.00 that was originally $50.00. How much did you save? The answer is zero, unless, of course, you bought the product for $25.00 and put the perceived $25.00 savings into your savings account. How often do you do that? In reality, no matter the so called original price, the real price is the amount you wrote the check for.
If you are thinking about buying the “deal” you have to ask yourself:
· Will my gross margins improve?
· If I reduce my prices by the amount of the “deal” will my sales increase?
· If so, how much?
· Will I be required to sell existing stock (not purchased on “deal”) at the lower price?
· Will net profits increase?
· If so, how much?
· What will my projected turn rate be at the end of the period?
· How will the purchase effect cash flow and cash available to service debt & expenses?
· Will I have to borrow funds to support the purchase?
· If so, at what interest rate and term?
· If I have to borrow to support this “deal”, how will this affect my cash flow?
· If the products don’t sell, will I have return privileges?
There are more questions that need answers, so don’t let the salesman put pressure on you. Just tell him, you will do an analysis and will let him know within 24 hours. Do yourself a favor and look back on your history with “deals. ”Study the numbers before you commit. Your working capital is at stake.
DISCLAIMER:
Joel Johnson is not a CPA or an attorney and is not in the business of providing accounting advice or legal advice. The information in this newsletter is offered as general business guidance. It is recommended that you contact your Certified Public Accountant or Business Attorney with questions for clarification. http://www.joelconsulting@aol.com