How Much Working Capital Do You Need?

Hi, Tom I have been tracking my current ratio according to your formula for years and years. Now I am selling my business. We have 13 employees, a four-color shop, $2 million in sales, and very good cash flow. The potential buyer is calculating that he is going to need $220,000 in working capital. He calculates this from the fact that my accounts receivable is about $220,000. I am taking the accounts receivable, so he will have zero A/R the first day (bulk or asset sale). But he is asking the bank for an additional loan for $220,000 to cover his working capital. I am telling him that is too much because some of our customers pay cash or within 30 days, so he will have cash coming in to make payroll and he can work with the suppliers to get 60- to 90-day terms for the first six months or so. Also, 15-20% of his A/R will be profit. I am telling him he should get a line of credit for $100,000 from his bank and that will be sufficient to cover his working capital until the late paying customers start paying. Is there a formula for calculating the amount of working capital a new owner should need? Printer in New England   Dear New England Printer Thanks, but I can’t take credit for the current ratio formula (current assets / current liabilities = current ratio). I think it was invented about the same time as dirt and the first balance sheet. Anyway, to your question of what current ratio your buyer should maintain, I say a 2:1, just like an older company. Why? Well, it might seem like a lot of cash, but trust me, it will be sucked up into receivables and inventory. And, although you correctly point out that many of the customers pay their bills within the 30 days after the end of the month (next month) and, further, that you can get 60- to 90-day terms from your vendors, you are overlooking one big point: the residual effect that inventory and receivables have on cash. When do you get your money out of inventory? No, it’s not when you collect from the customer. That’s because most all of us keep inventory on hand. So, if your inventory averages $5,000, then you will never get that $5,000 back until you shut down the business. That’s because you are constantly buying inventory for the next job that comes in. Think of it as that last quarter tank of gas we usually carry around in the car. If we fill up every time we get down to a quarter tank, well, there’s a quarter tank of gas that will always ride around with us. By the way, you can create extra cash by reducing the average inventory on hand, which is why the concept of “just in time†inventory became so popular with American manufacturers. Same thing applies to accounts receivable. We start the business with no one owing us anything and then we add the first 30 days of “charge†sales to accounts receivable. Now, it’s true that we are typically paid in the second 30-day period for the amounts charged during the first 30 days, but while we are deducting the payments, we are filling up our tank again with the new charges from the second 30 days. As a result, there is a residual in inventory and accounts receivable that you will never get out unless and until you close down the business. Now, on the flip side, there’s a residual in accounts payable as well. That means you charge items during month one that are paid in month two, but you are also charging additional items in month two as you pay, so there’s a residual there (like borrowing money). How much should the new buyer plan for? Well, at a minimum, I would expect two weeks of inventory on hand at any one time. And if your direct materials are 25% of sales, then you could use the following formula: Annual sales x 25% = direct materials for year / 52 weeks = weekly usage of direct materials x 2 = estimated inventory on hand at any one time Now different businesses have different direct material percentages of sales. An auto parts store would have a much higher one than a print shop, for instance—probably 50% or more, compared to the print shop’s 25%. Nonetheless, the calculation is the same. Additionally, one has to consider how long it takes to obtain the inventory. Two weeks is common inventory for items that are readily available, but in some cases it takes months to receive. In those cases, the amount of inventory may be greater. In the case of accounts receivable, if the terms are net 30, then you can expect something like 35 to 45 days of charge sales in receivables and the residual effect is the same. So the calculation there is easy as well: Year’s sales / 12 = 360 = days’ sales x 35-45 (choose your number of days) = total AR Note that I divided by 360 instead of 365 days, which is an accounting convention. Also I know that most folks aren’t open 360 days a year, but calendar days are typically used. OK, now your buyer can estimate his beginning balance sheet (pro forma) and then work backwards to see what he needs in absolute dollars As a final note, realize that most businesses do not have a good 2:1 current ratio to start, and often end up thinking they’re always supposed to be without cash, get accustomed to it, and always live that way. Finally, note that most banks will either not loan for working capital or will limit the total amount. Anyway, let me know if you need more on this. One of my favorite topics… Tom

Loading