Operating Money - Do You Have Enough?
I’m on a mission to show that you don’t have to be an accountant or even a rocket scientist to manage the financial side of your business. There are many simple tools that you can use and that are very easy to learn. This particular tool can be used to show what happens when sales increase or decrease and the impact it has on your accounts receivable, inventory levels, accounts payable and need for financing. For calculation purposes all items are expressed in terms of how many days sales they represent. You have the option of using the number of days in the calendar year or the actual number of business days pertinent to your business. Now obviously some days sales will be higher than others but by considering the number of days in the year we are looking at the average days sales for that period which is sufficiently accurate for our purposes. To use this tool effectively we need to know four numbers all of which will be expressed in terms of their dollar value. Namely your annual sales figure, your accounts receivable, your inventory, and your accounts payable. Consider the following scenario.
Accounts Receivable $300,000
Accounts Payable $100,000
One of the most important things a business needs to know to be able to operate efficiently and to be financially stable is how much operating money it requires. This amount fluctuates with the level of sales the business is making. So, lets use the above numbers to see how this works. Let’s figure out how much operating money we require to support this level of business. First let’s look at the items that tie up cash. These are Accounts Receivable and Inventory. However, our suppliers through the amounts outstanding in accounts payable are helping to carry our investment in the accounts receivable and inventory. Accordingly, the amount of operating money that we require is the difference between the amount tied up in accounts receivable plus inventory, and the amount outstanding in accounts payable. By converting all these numbers to days sales, you can quickly run scenarios for sales increases and decreases and analyse the impact these scenarios will have on the business.
Therefore, you would need operating monies of approximately $400,000 to operate for a sales level of $1,200,000. In this scenario this money would have to come from one or a combination of reinvested profits, new investment, or a bank line of credit. You could also slow down the rate at which you paid your suppliers.
One of the biggest challenges a business can face is rapidly expanding sales; let me show you how to use this tool to help you find out how much additional operating money your business will need. If sales double and all our other ratios stay the same our daily sales computes to 2,400,000/365 or $6,575. Since we need 121 days sales for our financing, we now need $6,575 x 121 or $795,575 in operating monies to support this level of sales. This increase in the operating monies required has to come from either a reinvestment of profits or new investment. The reason being you are tying up more money in inventory and accounts receivable. This reduction in the amount of operating monies required is why oftentimes if a business runs into cash flow problems the solution is often to decrease sales not increase them.
In many ways, a better way for a business to increase profitability is to first look for efficiencies. For instance, if sales stay at $1,200,000 and if you can improve your average collection of accounts receivable from 91 days to 60 days it reduces your need for financing from 121 days sales to 90 days sales or $259,920, a reduction of approximately $102,000 of financing and the subsequent savings in bank interest paid. Other similar solutions might be to reduce the amount of inventory required or to slow down the rate at which you pay your suppliers. All of which reduce the amount of operating monies your need.
As you can see this tool is very flexible and can be used very quickly to look at different scenarios within your business and to identify areas of your business that can be improved. It also gives you a key performance indicator that you can use to track the progress your business is making, as it is relatively simple to track your daily sales.