In order to manage its cash flow a business needs to understand the working capital calculation. Working capital is the amount of cash needed to fund the normal day to day trading operations of the business. In a simple business the calculation is as follows.
The net working capital represents the funding needed to buy inventory and provide credit to customers, reduced by the amount of credit obtained from suppliers.
A well operated business needs to have an understanding of its working capital calculation and requirements so that it can quickly estimate what it’s cash needs will be. Working capital is a component of cash flow, and as such, as it increases the requirement for cash increases.
An Example of the Working Capital Calculation
As revenue is a readily available figure it forms the basis of the calculations, enabling a business to quickly estimate its working capital requirements. The working capital calculation for each component is explained separately below.
Suppose a business gives credit to it’s account customers of 60 days. At any point in time (ignoring sales tax) the accounts receivable can be estimated as 60/365 x revenue. So for example if the business had sales of 200,000, the working capital calculation shows that the funding required for accounts receivable is as follows.
Funding required for accounts receivable = 60/365 x Revenue Funding required for accounts receivable = 60/365 x 200,000 = 32,900 (rounded)
What this calculation shows is that on average the business will need 32,900 in cash to fund the credit offered to account customers.
To allow for sale tax on the accounts receivable multiply by the rate. e.g. in the above example, if the sales tax was 20%, then the funding requirement would be 32,900 x 120% = 39,500.
Suppose the same business holds 60 days inventory. On average the sales value of the inventory held is going to be 60/365 x revenue. However the cash invested in the inventory is the cost not the sales value. Assuming the business has a gross margin of say 60% (i.e. the cost is 40% of revenue), then the cost value of the inventory is as follows.
Funding required for inventory = 60/365 x Revenue x Cost of sales % Funding required for inventory = 60/365 x 200,000 x 40% = 13,200 (Rounded)
Again what the working capital calculation is showing is that the business will have an estimated 13,200 of cash tied up in its inventory.
The working capital requirements of the business so far have both been cash outflows. Accounts payable represents credit supplied to the business by its suppliers, and as such helps to offset the cash outflow requirements. If the business takes credit from the suppliers then it does not have to pay them cash.
There are two main elements to accounts payable, the first is for inventory and the second is for overhead.
For inventory accounts payable we use a similar calculation to that shown for inventory above. Suppose the business can get 30 days credit from suppliers. Using a similar calculation as for inventory (as the business will buy at cost from the supplier not at sales prices), the working capital calculation shows that the funding provided by suppliers is as follows.
Funding provided by inventory payables = 30/365 x Revenue x Cost of sales % Funding required by inventory payables = 30/365 x 200,000 x 40% = 6,600 (Rounded)
So the working capital calculation shows that the amount of cash funding needed reduces by 6,600 because of credit given by inventory suppliers.
For overhead accounts payable, an estimate has to be found based on the annual overhead in relation to revenue. By dividing annual overhead by the annual revenue the business can calculate that for example, overhead is currently 25% of revenue. If the business gets 30 days credit from suppliers then the working capital calculation would be as follows.
Funding provided by overhead payables = 30/365 x Revenue x 25% Funding required by overhead payables = 30/365 x 200,000 x 25% = 4,100 (Rounded)
So the working capital calculation shows that the amount of cash funding needed reduces by 4,100 because of credit given by overhead suppliers.
Net Working Capital
In the above example we saw that the working capital requirement is as follows:
|Accounts receivable||32,900||60 / 365 x 200,000|
|Inventory||13,200||60 /365 x 40% x 200,000|
|Accounts payable – inventory||-6,600||30 /365 x 40% x 200,000|
|Accounts payable – overhead||-4,100||30 /365 x 25% x 200,000|
|Net working capital||35,400|
In this particular example the working capital requirement is 35,400 which equals 35,400 / 200,000 = 17.7% of revenue. This figure of 17.7% now gives a simple calculation at any point in time to estimate working capital requirements.
Suppose the business anticipates an increase in monthly sales to 25,000, this is equivalent to 300,000 per year, and the working capital is as follows.
Net working capital = 17.7% x Revenue Net working capital = 17.7% x 300,000 = 53,100
The working capital requirement has increased from 35,400 to 53,100 an increase of 17,700.
This amount of cash will need to be provided by increased bank facilities or by changing the levels of inventory, accounts receivable, or accounts payable days to bring down the requirement to previous levels.
To generalize this calculation we can write the working capital requirement as follows:
Cost of sales% x Inventory days / 365 –
Cost of sales% x Accounts payable days for inventory / 365 –
Overhead % x Accounts payable days for overhead / 365)
In the example above we use the formula at the start of the year to give:
Net working capital = Revenue x (60/365 + 40% x 60/365 - 40% x 30/365 - 25% x 30/365) Net working capital = Revenue x 17.7%
You only need to do this calculation periodically (depending on how rapidly your business is changing) to give the percentage to apply to your current revenue levels. In a stable business the percentage tends not to change a great deal.
Other Definitions of Working Capital
The above definition of working capital is a narrow definition representing the day to day operating working capital required by the business. The definition assumes cash is a non-operating asset and therefore it is excluded. This narrow definition is sometimes referred to as non-cash working capital.
A wider definition of working capital will include all current assets and current liabilities.
Current assets includes cash and cash equivalents, inventory, accounts receivable and marketable securities that the business uses or converts into cash within a year.
Current liabilities includes accounts payable, accruals and short-term debt which are due for payment within a year.
Working Capital Calculator Download
A working capital calculator is available for download in Excel format by following the link below.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.