Getting Working Capital Right is Critical. Here’s How to Do It

Working capital is just a fancy way of saying, “Do you have enough in short-term assets (preferably cash) to cover your short-term liabilities?” Or, stated more bluntly:

-> Can you make the next payroll?
-> Can you make the next check run?
-> Can you pay your suppliers this week?
-> Can you make your next bank payment?

…without borrowing money or adding personal capital. The easier you can cover your short-term cash crunches, the better your working capital position. Usually, businesses with inventory struggle with working capital more. That makes sense. When you buy inventory and hold it, extend credit to your customers, and pay for inventory before collecting, you’ll have working capital pressure.

I’ve struggled with this and figured out why. The way it’s normally analyzed is to ask questions like:

-> How much cash should I have?
-> How much receivables should I have?
-> How much inventory should I have?
-> How much payables should I have?
-> How much sales should I have?
-> How much expenses should I have?

Conventional wisdom says, “what should each account or category be?” Wrong question. Every business has different needs, even those within an industry. You may need to hold more inventory to meet demand or supplier lead time. You may have higher overhead because of a transition or limited automation. You may have seasonality in your sales. Maybe spring is great, and winter is terrible. It makes more sense to calculate working capital needs, compare it to actual working capital, and figure out if you’re in good shape or short. Then you can act.

There is no magic solution, but I found the closest thing to it. It’s called a “Bardahl analysis.” Hat tip to Gary Trugman, CPA/ABV, MCBA, ASA, MVS for providing the Bardahl analysis in his book, Understanding Business Valuation, A Practical Guide to Valuing Small to Medium Sized Businesses.

What Should Working Capital Look Like? Business #1
Let’s look at Business #1. Running it through Bardahl, it looks like this:

They’re not flush with working capital but they have enough. $14,000 is better than negative.

Coming Up Short. Business #2

Here, there’s a significant working capital deficiency of almost $100,000.

What Should You Do if You’re Short?
If you calculate a deficit, it could be one or several issues. Let’s figure this out.

  • Are you holding too much inventory? Maybe you can cut back and still meet demand.
  • Are you collecting from customers? A/R drifting over 30 days is a red flag you aren’t collecting well.
  • Are you taking advantage of terms vendors offer you? If A/P is turning too quickly, you may need to pay less frequently. Don’t be a deadbeat but don’t be silly either. Paying too soon short-circuits your working capital.
  • Are you carrying too much short-term debt? Too much debt due within a short time can pressure working capital.
  • Do you have enough sales for your headcount? Sometimes, you have too many people and the sales per employee doesn’t work.
  • Are your gross margins adequate? Do they stack up in your industry? Low performing gross margins can indicate poor purchasing, too much discounting, or poor pricing.
  • Is your overhead too high? Maybe your non-inventory costs are too high for a business with your level of sales.

Notice that Business #2 had higher operating expenses and A/R and lower A/P. That’s why working capital came up short. Pull one or a few of these levers and you’ll figure out why you’re short working capital. Then you can determine what adjustments you need to make.

The Excel tool is here and it’s free: Working Capital Bardahl

If you’re struggling with the accounting, please let me know if you need help.

Thanks,
Josh

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Can I Help You?
Hi, I’m Josh Horn, CPA/ABV, CVA of Horn Valuation. I help with business valuations in friendly or unfriendly situations. I also help owners build valuable companies. My clients are business owners and attorneys. If you’d like more information, check out my website hornvaluation.com, email me at josh@horncpa.com, or call me at 217-649-8794.

Josh Horn CPA

I’m a licensed Certified Public Accountant (CPA) and double-credentialed in business valuation (CVA & ABV). I’ve been a tax and business consultant in a top 100 CPA firm and a controller in a large international company. I’ve also valued and been the primary advisor to multi-million dollar and small companies in various industries.

“If you’re not working on business value, who is?” Josh Horn, CPA, Certified Valuation Analyst and Accredited in Business Valuation

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