The simpler way to measure working capital
If you’re a cash-based business, this post is not for you.
This post is for those of you who buy inventory and/or sell products or services on credit.
Remind me again, what’s working capital?
Working capital represents the time that elapses between:
- when you pay for things from your vendor, and
- when you get paid from your customers
That’s why it’s measured in days. Your goal with working capital is to quickly convert your inventory and accounts receivable into cash.
What’s the formula for calculating Total Working Capital Days?
What do the textbooks say?
Accounting textbooks tell you to use Cost of Sales when calculating DIO and DPO, and Net Sales when calculating DSO.
What’s the simpler and better way?
Use Net Sales across the board. It looks like this:
- DSO: Accounts Receivable / (Annual Net Sales divided by 365 days per year)
- DIO: Inventory / (Annual Net Sales divided by 365 days per year)
- DPO: Accounts Payable / (Annual Net Sales divided by 365 days per year)
By dividing each balance sheet item by your average daily sales, you tie working capital performance to one day of revenue (or to your revenue-to-cash cycle).
How often should I check-in on this metric?
Working Capital Days is a metric that you track monthly, monitor its performance over time, and identify ways to improve it.
Right now, you’re probably paying for goods when you buy them and collecting cash from B2B customers in 30 days. But in time, as your startup becomes more successful, vendors will extend credit terms to you (e.g., pay in 30 days). So make sure to ask for it! If your vendors aren’t ready to extend 30 day terms, ask them to start with 15 days.
Can I see Working Capital Days in action?
Let’s take a look at how Amazon’s working capital serves as a competitive advantage (sourced from Amazon’s 2014 Annual Report):
Note that for most companies negative working capital is a bad thing. In other words, the company doesn’t have enough inventory and accounts receivable to turn into cash and pay for its accounts payable. However, in Amazon’s case, negative working capital is a good thing. Amazon is incredibly efficient at managing it’s working capital. So efficient that its suppliers are extending financing to them.
With a negative working capital days of (11days), Amazon sells its merchandise and collect its cash before it has to pay its suppliers (57 days vs. 68 days). In turn, Amazon is able to take the 11 day difference between collecting cash and paying its suppliers (or $2.7 billion) and earn interest on it. Interest is now a revenue stream.
Originally published at facingthenumbers.com on April 20, 2016.
