Why Should You Learn How to Understand Working Capital?
Small business owners and managers have an important role to play in the health of the U.S. economy. Recently, on a national television
news show, Tim Reynolds of the National Small Business Association presented the following information: There are more than 27 million small businesses in the U.S., accounting for more than 99.7 percent of all American businesses. Sixty-five percent of the fifteen million net new jobs created between 1993 and 2009 are attributed to small businesses.
U.S. small businesses employ more than half of all private sector employees. Since small businesses are so critical to the future of the U.S. workforce, a manager’s understanding of financial statements is imperative for the health of the economy as well as that of his or her own company.
Do you know how to read financial statements? Except for the very smallest businesses, financial statements should be prepared on a monthly basis. Financial statements prepared quarterly or less frequently present data 90 days or more old. Unless you’re an accountant, your financial statements should be prepared by a professional. Accounting is a highly technical subject, requiring a good deal of education, training, and experience. However, you can learn how to read, analyze, and interpret financial statements and to use them to help you run a more successful business. This article deals with current working capital and how to improve it.
The first category on the asset side of your balance sheet lists current assets; the liability side lists current liabilities. Current assets are items that are converted to cash within one year and are available to pay liabilities. Current liabilities are obligations which must be paid within one year. A partial balance sheet looks like this:
Accounts Receivable $50
Prepaid Expenses $10
Total Current Assets $200
Accounts Payable $40
Note Payable-Bank $40
Sales Taxes $7
Accrued Expenses $13
Total Current Liabilities $100
Working capital, sometimes called net working capital or current working capital, is the difference between current assets and current liabilities. Assuming all the above numbers are in the thousands, working capital in this case is $100,000. Another way to look at this is that there appears to be two dollars available in current assets to pay each dollar of current liabilities. The ratio of current assets to current liabilities is $200 to $100 or 2 to 1. Many people think that a ratio of 2 to 1 is good. As a matter of fact, some textbooks use the 2 to 1 ratio as a typical example.
However, the company in this example is facing a cash shortage because inventory of $120,000 and prepaid expenses of $10,000 are not available to pay current liabilities. Subtract these two numbers out of current assets, and only $70,000 is left to pay $100,000 in liabilities. The ratio is now $70 divided by $100 or 0.70. You simply will not be able to pay each dollar owed with 70 cents. This ratio is called a quick ratio or acid test ratio, and really is an acid test of your ability to pay your bills when due.
Here's why the inventory and prepaid expense numbers are pulled out of the total. Inventory is not available to pay current liabilities because
inventory has to be replaced. Inventory cannot be reduced without experiencing out-of-stock conditions. If you liquidate inventory, you will also liquidate sales. This analysis assumes, for the problem only, that $120,000 is the correct level of inventory. Whether that is true is a topic for a different discussion. Inventory, although properly classified as a current asset according to the accounting rules, actually has the characteristic of a long-term asset.
Generally, banks understand that inventory has little value as collateral and are reluctant to lend money on inventory; those banks that do may only lend 10 or 20 percent of the amount shown on your books. Prepaid expenses are not converted to cash because they represent items already paid. Thus, inventory and prepaid expenses are not available to pay current creditors.
What appears at first glance to be adequate working capital is very misleading. Simple analysis reveals that this company is already experiencing cash flow problems. The owner spends all of his time on Thursday or Friday trying to collect enough receivables to make payroll one more week. If you are in this situation, you know what a burden this can be physically, psychologically, and emotionally. Too many small businesses experience this scenario much too often. That's why it is so important to know how to read financial statements.
Here’s the Fix
Although the $40,000 note payable to the bank may not be an inventory loan, it is supporting the inventory. Since the inventory cannot be sold off to repay the bank, it should be supported by a long-term loan or equity. There are several things that can be done, but a quick and simple solution is to refinance the $40,000 note payable to the bank on a long-term basis, assuming the company or its owner has the financial capability to make the deal.
Moving that $40,000 out of current liabilities and into the long-term liabilities section (not shown here) is more than the act of shuffling numbers around on the page. This very simple change in financial structure has an immediate and positive effect on your ability to run the company. The working capital is now $200 minus $60, or $140, up from $100. The current ratio is more than 3 to 1, and the acid test ratio is $70 divided by $60, or $1.17 for each $1.00 in current liabilities.
The importance of managers learning how to read their financial statements can’t be overstated. Look at your own balance sheet. If you see any similarity to the pattern in this problem, or if you are having cash flow problems, tackle this issue first. You may find your days much less stressful and be able to focus more energy on generating revenue.