The head of finance or the person responsible for this management should be sophisticated in business and experienced with the company’s operations. In small business, this function is typically performed by the owner or the Certified Public Accountant for the company. This article explains the first of these three elements and the various attributes involved. There are several examples provided to assist the reader in understanding these underlying concepts. If not fully comfortable with the basics of working capital, please read the following in order to fully grasp the fundamentals of working capital:
This article is long which correlates to the subject matter at hand. Please take your time and take a break as necessary.
Understanding the Forms of Current Assets and Current Liabilities
By far the easiest and best form of any asset is cash. The flexibility and acceptance of cash makes this particular asset the most coveted. On the flip side, any liability with flexible payment terms is preferred over the more rigid requirements of some liabilities. Consider for example the difference between a line of a credit and a note payment.
* Line of Credit – A bank instrument allowing the customer (borrower) to borrow money at will. In addition payments are made as deemed fit by the customer. The instrument has a drop dead date for full payment. Most often the agreement is for one year. This type of instrument provides maximum flexibility and has no punitive repercussions.
* Note Payable – At the other end of this financial relationship is a note payment requiring regular monthly payments. Failure to pay on time triggers punitive damages and possible repossession of physical assets.
All other liability cycles exist between these two extremes.
Current Assets Flexibility Attributes
Cash N/A (Maximum)
Accounts Receivable Commonly 30 days, but is industry based
Inventory Ideally less than 30 days
Prepaid Expenses None due to amount of time to request and receive refund
Accounts Payable – Production Generally 30 days to pay
Accounts Payable – Operation Varies but never exceeds 30 days
Credit Cards 14 – 21 days
Accrued Payroll/Expenses Triggered by event/specific date
Accrued Taxes 3 – 15 days depending on authority
Line of Credit Highly flexible
Current Portion of L/T Debt Less than 30 days; 1/12 of balance
As an owner or finance manager you must fully grasp the underlying elements of each of these eleven different cash cycles (both inflows and outflows) to understand their respective timing attributes and the impact each has on cash. The following subsections walk through ten of these cycles (excludes cash) and highlights their unique elements. Examples are provided for clarity and there are more resources for each available on this site.
Even with the best accounts receivable management processes there will still be large sums of amounts owed to the company from customers. The key to understanding payment cycles is to look at the past and use history to track the future inflows. In a typical large volume invoicing operation, those invoices generated today will be paid 23 to 30 days from now. Therefore, those invoices generated three weeks ago will get paid this week. So on average about 20 – 25% of the accounts receivable balance will be paid this week. Another 20 – 25% next week and so on. Some weeks may see more, while others will obviously be less.
Naturally this isn’t true with every company. Those in project based operations will have greater dispersions of time between payments and significant inflows of cash when payment is received. So the volatility of accounts receivable is much higher for project based operations.
This is also true for limited customer based operations. Those with very few customers but significant volume per customer must go beyond simple accounts receivable cycles and understand their customer business cycles. Here are a couple of examples:
Sometimes accounts receivable cycles are tied to contractual performance issues. So understanding contract law and the respective terms of the contract with the customer is tantamount to understanding payment timing. Often the receivables department doesn’t understand why no payment has been received until communication with the customer identifies the unresolved issue in the contract. Customers are reluctant to pay until 100% satisfied. Again the accounts receivable management process pinpoints the problem early on in the cycle.
Unlike accounts receivable, inventory is lower or further out in the overall working capital cycle to ultimately become cash. In general inventory is product available for sale. So in a traditional exit payment retail environment where cash is paid for the product, the inventory to cash cycle is short. Think of a convenience store where some products turn quickly like cigarettes and beer. Others have longer turnover periods like diapers or cans of fruit on the shelf (people buy these products at the discount store).
To go beyond the retail environment, think of business to business models and the turn rate involved with their inventory. Here are some examples:
Now the inventory changes from a physical item into an accounts receivable (paper) balance. Assuming 30 days to get paid, the entire inventory to cash cycle takes upwards of 90 days.
In some industries, inventory to cash can take years!
What is important when evaluating inventory is understanding the turnover time for inventory. Naturally, the longer the cycle the greater the need for working capital. In addition, volatility of business performance increases too.
The particular asset is an anomaly in accounting. Basically the company purchases particular services or products in advance and then amortize this cost over a 12 month period. Here are some of the more common prepaid expenses:
A) Insurance – Insurance is often prepaid based on the agreed contract with the underwriter, especially property insurance for real estate intensive businesses such as condo associations, apartment complexes, office buildings and commercial facilities. Often the mortgage document requires insurance paid in advance for at least 12 months.
B) Real Estate Taxes – Very similar to property insurance, many counties require tax payments in a prepaid format and not post pay.
C) Software Packages – Many licenses to use software packages require an annual upfront payment. The business then amortizes this payment out over the 12 months of use.
D) Data Storage – A relative newcomer in business, data storage such as databases or cloud storage require prepaid contracts for a year. This includes such fees as the website domain and website space. Just as with the other forms of prepaids, the cost is amortized over 12 months.
As this pertains to working capital management, it is best to omit this particular current asset from the formula for several reasons:
1) Technically it is a prepaid liability; i.e. the particular expense is automatic and rarely a one time event. Think of all four examples; they are mandatory every year.
2) The asset value can not be turned into cash, the cash has already been utilized to pay for the particular expense.
3) Even if the business decided to retrieve the cash, say they renege on the insurance policy, the penalties involved and the increased risk would far exceed any value derived from the use of the cash.
This account in the current liabilities section of the balance sheet has two sub accounts. The first and most commonly used is accounts payable for production. Those materials or products used to make or act as the final product for sale to the customer. Typically the suppliers are referred to as vendors or subs.
The bills received for materials or product typically have 30 day grace periods for payment. Sometimes vendors allow longer periods of time to pay especially for seasonal products, specialty items or volume purchases as illustrated below.
The second type of accounts payable is operational expenses, those costs for general overhead and selling. These include the following:
1) Rent 6) Utilities
2) Office Supplies 7) Maintenance and Cleaning
3) General Insurance 8) Professional Services
4) Worker’s Compensation Ins 9) Technology
5) Advertising Costs 10) Banking/Costs of Capital
In general most of these bills demand payment in less than 30 days but recur every 30 days; think of rent and utilities. Sometimes the bill isn’t recorded until the middle of the month but is due at month’s end.
As a business manger, although the bill may not be recorded, it should still be considered in management of working capital.
Credit card companies send statements and not bills. There is an entirely different process to manage credit cards as explained in Lesson 42 – Purchases Via Credit Cards. There is give and take using credit cards in business. Flexibility increases because there is no 100% demand for the balance due; however, any balance unpaid in the monthly cycle carries a higher interest rate cost than a line of credit account.
Accrued Payroll Expenses
During each payroll run and employer also includes, by accruing certain benefits, costs associated with the payroll. These costs include:
* Gross wages value of vacation earned
* Gross wages value of sick leave earned
* Employer/Employee contribution to a retirement plan
* Employer amounts owed for life insurance, dental, vision insurance, etc.
Notice that none of these expenses are tax related?
This is because payroll and other taxes are accrued as a liability in a separate liability account (see below).
Each of the above individual expenses have different payment cycles. Often insurance products are paid in advance of coverage. Others are triggered by certain events including illness and vacation times each year (summer and holidays). When addressing payment times, the owner/finance manger should use tests of reasonableness to determine how much cash will actually be needed over certain periods of time.
The accrued taxes are divided into three distinct groups:
The first two are self explanatory. The last group includes the following:
* Sales and Meal Taxes
* Revenue and Licensing Taxes
* Certifications, Transportation Tags/Registration and State Authority Licenses
* Property, Real Estate and Asset Based Taxes
Each of these taxes have different cycling times. For example sales taxes are customarily due monthly by a certain date; whereas Federal Income Taxes are paid quarterly.
Line of Credit
Of the various types of bank loans [link to article – Various Types of Bank Loans] the line of credit is the most flexible. Often extended to well established business operations or high FICO score owners, lines of credit act as a cushion or a safety net during leaner times. It is very similar to a credit card except it is used to provide cash. Some businesses use it as a funding tool or primer to start a long-term contract; or to purchase product for a seasonal sale. Below is an example of a line of credit use.
Typical lines of credit are tied to the personal financial worthiness of the owner. It is a recourse, thus allowing for more flexibility.
Current Portion of Long-Term Debt
Under generally accepted accounting principles (GAAP) long-term debt is divided into two distinct components on the balance sheet. The primary component is the remaining principal balance less the principal balance due over the next 12 months. The second component is classified as current and it is the principal portion of long-term debt due during the next 12 months. The formula looks like this:
This means this particular account includes all the respective 12 month principal payments for all the long-term notes. In general, you should expect 1/12 of this total will be needed over the next 30 days. In effect there are 12 sub cycles within this dollar value.
First Caveat to this Concept: Some notes have a call provision ( a tool to force refinance) at some point in the note. When this call provision value comes due within the next 12 month period, i.e. it becomes current; the entire remaining principal balance for that note is reclassified as current. It is relatively easy to spot because the current portion of long-term debt balance will seem to be unreasonably high. This greatly affects working capital management. Naturally the best solution is to refinance the note.
Second Caveat to this Concept: Interest amounts for these note payments are NOT included in the current portion of long-term debt. Current portion is strictly limited to the principal portion of debt payments. When evaluating working capital management, keep this interest portion of debt service in mind.
Summary – Working Capital Management
Working capital is defined as all current assets less current liabilities. However, the most important current asset is cash. All creditors want payment in the form of cash. So timing of cash receipts and corresponding liability payments is dependent on good cash management.
Working capital management is a function of financial management whereby the business ensures there is adequate cash to meet the day-to-day, weekly, monthly and quarterly needs. To successfully plan the inflows and outflows of cash, the finance director must first understand the cash cycles of the individual accounts for both current assets and corresponding current liabilities.
Each of the current asset accounts and current liability accounts have a different cash cycle time. Some are strict in nature, others more flexible. Understanding these individual account cycles is the first element of three involved in working capital management. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.