working capital

As if there aren't enough figures dancing around the left side of your brain, here's another concept that you need to have a grasp on if you want to stay on top of your business. It's not enough to make profit; you also have to manage your working capital. Working capital is the cash that you must have invested in your business to operate on a day-to-day basis, and is not to be confused with capitalized costs/fixed assets, such as a kiln or a drill press. However, they are related to the extent that if you invest in a new kiln to double your business, then most likely your working capital needs will increase accordingly.

These are shadowy costs that aren't apparent using classical bookkeeping methods, but their effects on your business can be dramatic. For the craftperson, the two major components of working capital are accounts receivable (the money owed you by your customers) and inventory (your stock of raw materials and supplies). How quickly you get paid for your shipments (referred to as day's sales outstanding)  and how often you replenish inventory (commonly expressed as an inventory turnover ratio)  determines the working capital required for your particular craft business.

In our example Crafts 'R' Us has the following income statement:

   Annual sales
  Direct labor
      Total direct costs
  Gross profit
  Indirect costs

The important thing to remember is that this is the income statement you or your accountant will develop regardless of what your working capital requirements are. Whether your terms to your customers are COD or Net 60 days doesn't matter. Whether you turn your inventory two times a year or six times a year doesn't matter. Your profit on the income statement remains the same.

Accounts Receivable. If all of your sales are COD, you still have some transit time involved for the craft widgets to get to the customer, and for the money to get back to you. Let's say that's 15 days. In this case the accounts receivable component of working capital is $4,100 (15 divided by 365 times $100,000). However, if you offer Net 30 terms and your customers start counting from when they receive the goods and don't cut you a check until the 30th day (which coincidentally falls on a weekend) then you probably won't see your money for 45 days, and your working capital requirement is now tripled to $12,300. If their season gets off to a slow start, you could be looking at 60 days or better ($16,400 or more).

Inventory Turnover. Let's say that you run a very efficient studio and can turn over your materials every two months, or six time a year. At any given time, then, you have an inventory of $4,200 ($25,000 divided by 6). But what happens if your supplier starts getting flaky on you, and you have to keep three months of inventory on hand to ensure that you don't run out of materials in the middle of a big order. Your turnover rate drops to four times a year, and the additional working capital is $2,100. It could be worse: turning your inventory only twice a year requires you to have an average of $12,500 on hand at any given time.

These figures are additive. In the best scenario you sell your craft widgets on a COD basis for an average accounts receivable of $4,100 and your turnover rate is six times a year for an inventory of $4,200. Your working capital requirement is therefore $8,300, and you are the one who invests that money in your business by not taking out profits equal to that amount. Now let's say that you are having a bad year: customers are taking 60 days to pay you, and your suppliers are so unreliable that you have to have six months of materials on hand to keep the flow going in your studio. Your working capital requirement just jumped by $20,600 to $28,900! Your profit remains the same at $25,000, but you only get to take home $4,400 of it because the business sucked up the majority of the cash. Guess what? It gets worse. The IRS is going to tax you on the $25,000 profit they see and take your $4,400 away. If you don't get a handle on your working capital quickly, you are going to have to take out a bank loan to feed the family.

Working capital is a mostly hidden cost of doing business, and is misunderstood by the majority of folks in business, including your accountant. You will always have working capital requirements, and the only way to minimize them is to stay on top of those areas of the business that give rise to them: your credit and collection policies, and your inventory management practices.


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