The big three of working capital are accounts receivable (A/R), accounts payable (A/P), and inventory. Let’s take a look at the common measures for working capital and how you can use them to interpret working capital performance.
Days Sales Outstanding (DSO)
Calculation – Accounts Receivable / (Annual Sales / 365 days)
A decrease in DSO (collecting money faster) is an improvement, and an increase is a problem.
Days Payable Outstanding (DPO)
Calculation – Accounts Payable / (Annual Sales / 365 Days)
An increase in DPO (taking longer to pay your bills) is an improvement. Be careful – if you take too long to pay, you could alienate important vendors and suppliers.
Days Inventory Outstanding (DIO)
Calculation – Year End Inventory / (Cost of Goods Sold / 365)
When DIO decreases, that’s a good thing! Remember – inventory is evil!!!!
Days Working Capital (DWC)
Calculation – (Accounts Receivable+ Inventory – Accounts Payable) / (Annual Sales / 365)
The lower the number the better the results.
Here are a couple of notes to consider. You can do these calculations at any time, and you don’t need the end of year numbers. You can do it for the quarter, too. Make sure you are comparing your numbers to other companies and your competitors. When you need help with benchmarks, there are many online resources that make it easy for you to do research.
To give you a feel for how some industries are doing, let’s take a look at DWC.
Industry Best Median
Building Prods 45 59
Software 4 58
Food Prods 18 45
Machinery 18 82
You can see there are some huge differences between the best and the average. The best get there by making working capital a priority, tying it to bonuses, making it a metric, and most importantly, using process improvements to create change.
Now that you understand the components, let’s take a look at practical business applications. When companies struggle with working capital, there are usually some underlying reasons.
1. They extend terms to customers – pay us in 45 days instead of 30
2. They keep high levels of inventory to sell any kind of combination of product to customers
3. They pay suppliers faster to make sure they have the right inventory.
Why do people do these things? For many, it’s a lack of understanding. Instead of getting burned on the working capital side, look to make changes in these areas:
1. Work on improving your forecasting process to reduce uncertainty.
2. Standardize terms for your customers – no exceptions.
3. If you’ve been successful in working capital management, keep working it.
4. Stay away from debt to finance investments in your company. Use working capital.
Gather information from customers, suppliers, and your own team. This information is the groundwork for improving your cash flow and profit.