4 working capital ratios you need to know – and how to calculate them

Being in business is like spinning plates and it can often be difficult to keep on top of everything that is going on. Developing situations can catch you by surprise and not leave you enough time to sort them out properly.

Even if you think of yourself as a non-finance person, your management accounts, whether produced by you, your book-keeper or accountant, are an important source of information and readily available from your cloud accounting software. Here are four trends that you should look out for when thinking about your liquidity.

  • Debtor days

    This is the average amount of time it takes you to collect payment from your customers. A long days debtors period will put strain on your cash flow as you are effectively acting as the bank to your customers. Money held in their bank accounts when it should be in yours means you have to find the money for wages and other overheads from other sources.

    Your debtor days are calculated like this:

    Outstanding debtors x 365
     Annual turnover

    The result should be at or near your normal terms of trade. For example, if you offer 30 days credit as standard on your invoices, your days debtors calculation should come out at or near to 30 days.

    There are a few things to look out for:

    1. An increasing debtor days could be the result of one or two customers that are consistently late in paying. Examine your debtors listing and decide if specific action is needed on these customers – do you need to get firmer with your collection methods, agree an element of payment in advance or put them onto a direct debiting arrangement?
    2. A long outstanding debt could be inflating your result and it might be time to consider writing this off in the books and getting the tax deduction for the bad and doubtful debt. This doesn’t mean that you can’t carry on activity in the background to obtain payment and treat is as a recovery later on, but it will give you a truer picture of your collection processes.
    3. Your outstanding debtors figure is a moment in time and if you choose a time in the month to calculate it when it is lower or higher than normal, it will skew your result.
  • Creditor days

    Creditor days is the opposite side of the coin and is the average amount of time you are taking to pay your suppliers. A long creditor days period means you are keeping your money in the bank for as long as possible, but be aware that you could be damaging your relationship with your suppliers – or even putting them under strain – which could result in them applying limitations to the credit they offer you in future.

    Your creditor days are calculated as follows:

    Outstanding creditors x 365
    Annual cost of sales

    As before, the result should be at or near the average terms that your suppliers offer you. A large figure or increasing trend could be an indication that you are struggling to pay your bills on time.

    Again, it’s worth taking a look at the details of your creditors before jumping to any rapid conclusions about the results.

    1. Examine your creditors listing and decide if you might be pushing your luck with any of them. Are they likely to take action which might, at best, damage your reputation and, at worse, force you out of business
    2. An increasing creditor days period could be the result of one or two suppliers that you are deferring payment on for good reason – perhaps you have a dispute. If so, it is worth adjusting for this.
    3. Like your debtors, your outstanding creditors figure is a moment in time and if you choose a time in the month when it is lower or higher than normal, it will affect the result.
  • Stock turnover

    Stock and raw materials awaiting sale or production will be costing your business money unless you have managed to organise payment terms with suppliers and customers in such a way that you can be paid for your product before you have to pay for the raw materials – no easy feat!

    Your stock turnover calculation will tell you how long you sit on stock before turning it into cash and is a good measure of efficiency. A high turnover shows that you are not overspending by buying too much stock and wasting resources on storing old or potentially redundant items.

    Stock turnover is calculated in a very similar way to the other ratios:

    Value of stock x 365
    Annual turnover

    Things to look out for with your stock turnover calculation include:

    1. A slow stock turnover rate could indicate that you have redundant stock in the business. You might need to think about having a sale to generate what cash you can from it, or even writing it off
    2. How you value your stock will have an influence on the calculation. You might be using First in, First out (FIFO), Last in, First out (LIFO) or an average weighted cost. Consistency is probably the key here.
    3. The moment in time situation is equally applicable, so you might prefer to use an average stock value if today’s figure looks unusually low or high
  • Quick ratio

    The quick ratio is also sometimes known as the acid test and brings everything together in terms of your business’s liquidity.

    In simple terms, it shows whether the business has sufficient cash and money owing to it to meet its short term liabilities. As such, assets such as stock are excluded because, as we saw above, it can be difficult to quickly turn this into cash at the book value.

    The calculation for the quick ratio is:

    cash + debtors (excluding doubtful debts)
    current liabilities

    Ideally, the result should be greater than 1 as anything less than this suggests that the business can’t meet its short term commitments without financial assistance, for example, with an overdraft facility. A low or reducing quick ratio is a sign that the business is consuming cash faster than it can earn it, which is only sustainable for a limited amount of time.

      So, there you have it – 4 must know working capital ratios. When managing cash flow, however, the most important skill is to be ahead of the game. Very few businesses operate cash positively all of the time and cash squeezes will inevitably occur on occasions. This doesn’t make it a bad business. Your ability to see these squeezes coming will allow you to act calmly and appropriately. Your bank and other financial stakeholders will also respond more positively to a business that is clearly in control. We have developed CaFE specifically to give small business owners alerts and the necessary information to act when future cash is forecast to be tight without them having to complete and update complex cash flow forecasts.
October 19, 2018 by Makoto Fukuhara Categories: Accountants and bookkeepers