Working Capital: Reengineered (Part II)
In a recent blog post we discussed working capital (read Part I here) and how lenders gauge the health of a business, from a working capital efficiency perspective, using various ratios. In this latest blog, we take the discussion one step further by reengineering the formulas we previously discussed and seeing what the new information tells us.
Let’s look at an example.
Assume your company has the following financial metrics which we’ll use to calculate Days Payables Outstanding (or DPO):
Accounts Payable this month = $20,000
COGS this month = $55,000
Days this month = 30
Based on the above, your company’s DPO is then: ($20,000 / $55,000) * 30 Days = 10.9 Days.
This tells us that in this month, you are paying your supplier invoices in 10.9 days on average.
Now let’s say that we know the industry DPO for your company’s sector is 30 days.
Thus, for whatever reasons (e.g. you’re vying for early payment supplier discounts, you’re a start-up with little clout to negotiate longer terms, etc.) you are paying nearly 20 days faster than industry average.
Now let’s reverse the formula. That is, instead of solving for DPO, we solve for implied accounts payable.
Implied Accounts Payable: (30 Days) * ($55,000 COGS / 30 Days/Mth) = $55,000 in accounts payable.
Because you extended how long you pay your suppliers, you’ve freed up $35,000 in additional working capital ($55,000 implied payables - $20,000 account payable). This happens as paying suppliers is a use of capital. Prolonging payment means you have more cash for other things, preferably those activities that are revenue-generating.
Thus in this example, you might forego using your overdraft or operating line by simply reducing how quickly you pay off your accounts payable.
Given many businesses in Canada are inventory-heavy, let’s look at inventory turn as well.
Again, assume your company has the following financial metrics which we’ll use to calculate Days Inventory Outstanding (or DIO):
Inventory on hand at month-end = $200,000
COGS this month = $55,000
Days this month = 30
Based on the above, our DIO is then: ($200,000 / $55,000) * 30 Days = 109.1 Days. This means your inventory turns over every 109 days on average.
Again, let’s flip the ratio around and assume that the average inventory turn for your company's sector is 50 days.
So the formula becomes: 50 Days X ($55,000 / 30 Days/Mth) = $91,667.
What this formula tells us is that if your company can turn its inventory over faster (50 days vs. 109 days currently), only buying what inventory is actually needed to meet current sales orders, and potentially liquidating obsolete inventory (if any), your company could free up $108,333 in working capital ($200,000 actual inventory outlay - $91,667 implied inventory).
Completing the exercise by calculating Days Sales Outstanding (or DSO), the speed at which your company collects accounts receivable, completes the analysis.
Looking at your working capital through a different lens can be quite telling. It can mean the difference between leveraging up your balance sheet (i.e. taking on more debt or using your operating line too heavily) or not. It can mean the difference between stronger net margins or weak net margins (i.e. faster collections = more money to reinvest in more inventory = more sales opportunities = more profit (all else equal)). And sometimes, as Kaeros has seen during the pandemic, it can mean the difference between being liquid and illiquid.
In sum, perhaps you’re looking at financing some working capital, either through a traditional operating facility, asset-based loan, or alternative debt. Or perhaps you just want Kaeros's help, on an advisory basis, to complete the above analysis for your company and show you where opportunities might lie to free up working capital organically. Either way, we’d be more than happy to speak to you.
Cheers, Trevor
Founder & Managing Director
Copyright 2019 Kaeros Capital Advisors Inc.