In Part 1, we looked at a 4 chapter story within the balance sheets. Then, using the below example, we demonstrated how each chapter shows the cash generated and how our theoretical company used it.

Part 2: Continuing the Story

In Part 2, we will now evaluate whether our theoretical company’s investment in working capital was a wise use of cash. But first, let’s get some additional information about the company’s performance during the period in question.

As a reminder, working capital is comprised of these balance sheet accounts:

• Account Receivable – What our customers owe us for products/services sold.
• Inventory – Consists of raw materials, work in progress (WIP), and finished goods inventory.
• Account Payable – What we owe our vendors.

We can evaluate these working capital accounts by looking at how much of each of them we have in terms of a “days supply” as follows:

Accounts Receivable Days (aka Days Sales Outstanding or DSO)

Ending Accounts Receivable divided by Annual Revenue X 365 days

Inventory Days on Hand (aka Days on Hand or DOH)

Ending Inventory divided by COGS X 365 days

Accounts Payable Days (aka Days Payables Outstanding or DPO)

Ending Accounts Payable divided by COGS X 365 days

In an environment of growing sales and their related COGS, you expect the related A/R, Inventory, and A/P to also increase. However, when you look at working capital per day, you expect the A/R, Inventory, and A/P per day to remain relatively unchanged. Therefore, increases in DSO and DOH or decreases in DPO require cash, and using cash to make those changes may not be necessary.

Using the selected financial information provided above, we can do the following calculations:

Account Receivable Days

Prior Year (DSO-PY) $2,600K / $28,500K X 365 = 33.3 days

Current Year (DSO-CY) $3,300K / $32,000K X 365= 37.6 days

Increase of 4.3 days. Since CY Revenue per day is $32,000K / 365 = $87,671, we may have used $377,000 ($87,671 X 4.3) more than we needed.

Inventory Days on Hand

Prior Year (DOH-PY) $3,400K / $18,300K X 365 = 67.8 days

Current Year (DOH-CY) $4,200K / $19,800K X 365 = 77.4 days

Increase of 9.6 days. Since CY COGS per day is $19,800K / 365 = $54,247, we may have used $521,000 ($54,247 X 9.6) more than we needed.

Accounts Payable Days

Prior Year (DPO-PY) $3,600K / $18,300K X 365 = 71.8 days

Current Year (DPO-CY) $3,600K / $19,800K X 365 = 66.4 days

Decrease of 5.4 days. Since CY COGS per day is $19,800K / 365 = $54,247, we may have used $293,000 ($54,247 X 5.4) more than we needed.

In total, based on how working capital was managed, the company’s management may have consumed $1,191,000 ($377,000 + $521,000 + $293,000) more cash than was needed to invest in working capital when only $309,000 was required.

There may have been good reason to increase DSO or DOH or to decrease DPO. But absent any good reasons, this company did not manage its working capital wisely.

We hope this two-part series has increased your financial understanding and given you some things to look at in your business. In today’s inflated marketplace, it is more important than ever to listen to the critical story contained within your balance sheets.

If you’re concerned about how your company manages its cash flow, contact iMpact Utah for our consultation services and training.