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Working Capital

See Also:
Balance Sheet
How to collect accounts receivable
Factoring
Quick Ratio Analysis
Current Ratio Analysis
Financial Ratios

What is Working Capital?

Use the following formula to figure out what is working capital.

Formula: Current Assets – Current Liabilities = Working Capital

Working Capital Definition

The Working Capital definition or WC is the difference between Current Assets versus Current Liabilities. Current Assets are those assets that will be turned into cash within one year, whereas Current Liabilities are those liabilities due within one year. This calculation represents the liquidity that a company has to meet its obligations coming due in the next 12 months. Though the amount should be positive, it can be a negative amount in times of distress.

Often used as a management tool, track the change in WC on a weekly basis. A company that is generating profits is usually increasing their WC. In comparison, declining profits often consume WC.

See Flash Report.

If you want more tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

Working Capital Definition
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Working Capital Definition

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Operating Capital Definition

Operating Capital Definition

The operating capital definition is the cash used for daily operations in a company. As a result, it is essential to the survival of each and every business. Whether small or large, across industries, and under any other conditions that a business faces, lack of cash is one of the main reasons why a company fails. Due to this fact, it is of key importance that businesses monitor and plan for future cash holdings to assure that the business will have the money needed to continue doing commerce.


NOTE: Want the 25 Ways To Improve Cash Flow? It gives you tips that you can take to manage and improve your company’s cash flow in 24 hours! Get it here!

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Operating Capital Explanation

Operating capital, explained as the most essential asset in any business, allows a company to stay open. Also known as working capital, it can come from many sources. Operating capital vs working capital is a similar comparison to red vs maroon apples: there is no difference.

The initial operating capital for small business will come from investors. This could come in the form of savings of the owners, friends and family of the owners, banks and the S.B.A., angel investors, or venture capital.

For an existing business, operating capital outlay will come from more providers than for the startup. The same options exist with current owners, friends and family, banks and the S.B.A., and more. Additionally, however, a business can receive operating capital loans from mezzanine financiers, factoring, or becoming a public company and selling stock on the open market.

Operating Capital Formula

Though the operating capital formula is a simple function of subtraction it is actually quite complicated. The difficult part of operating capital requirements is the research associated with finding current asset and current liability amounts. Once these questions are answered the operating capital ratio comes naturally.

Operating Capital = Current Assets – Current Liabilities

Operating Capital Calculation

The operating capital calculation is quite simple.

If:

Current Assets = $1,000,000

Current Liabilities = $250,000

Operating Capital = $1,000,000 – $250,000 = $750,000

Managing your cash flow is vital to a business’s health. If you haven’t been paying attention to your cash flow, access the free 25 Ways to Improve Cash Flow whitepaper to learn how to can stay cash flow positive in tight economies. Click here to access your free guide!

Operating Capital Example

For example, Chris is the CFO of a large company – a series of retail stores which sell plants for home decor. Chris plans the company finances to assure smooth operations. This includes managing company operating capital.

Recently, the company has experienced enormous growth. While this is a great signal that the business model is sound, it can also form a operating capital crisis. Consequently, Chris must move forward carefully to avoid financial ruin for the company.

First, Chris wants to know where the company stands. He then performs this working capital calculation to see where the business is currently:

Current Assets = $1,000,000

Current Liabilities = $250,000

Operating Capital = $1,000,000 – $250,000 = $750,000

Chris knows that $750,000 is not enough money to get the company through this quarter. He also knows that with insufficient working capital the company will have to seek financing from a lender who is less risk averse. So Chris does his research.

The two choices Chris learns are possible are factoring and mezzanine lending. Therefore, Chris will need to do a lot of research to evaluate both options. As he does this research, he is empowered by the importance of his work: the fate of the company rests upon it.

Conclusion

In conclusion, Chris chooses mezzanine lending as the option for the company. With mezzanine lending, he can have a total cost of capital lower than that with factoring. Additionally, mezzanine lenders will offer more money that that in the value of the receivables of the company.

Chris moves forward carefully in order to avoid a mistake. Because his nature as a planner makes this path an easy one, Chris will wait until he is prepared and then make the proper decision.

For more ways to improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.

Operating capital

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Inventory to Working Capital Analysis

See Also:
Financial Ratios
Mining the Balance Sheet for Working Capital
Are You Collecting the Data You Need to Run Your Business?
Net Sales
Net Income
Letter of Credit

Inventory to Working Capital Definition

Inventory to working capital ratio is defined as a method to show what portion of a company’s inventories is financed from its available cash. This is essential to businesses which hold inventory and survive on cash supplies. In general, the lower the ratio, the higher the liquidity of a company is. However, the value of inventory to working capital ratio varies from industry and company. In conclusion, the better benchmark is to compare with the industry average.

(NOTE: Want the 25 Ways To Improve Cash Flow? It gives you tips that you can take to manage and improve your company’s cash flow in 24 hours!. Get it here!)

Inventory to Working Capital Explanation

To better explain inventory to working capital, it is an important indicator of a company’s operation efficiency. Note that a low value of 1 or less of inventory to working capital means that a company has high liquidity of current asset. While it may also mean insufficient inventories, high value inventory to working capital ratio means that a company is carrying too much inventory in stock. Because excessive inventories can place a heavy burden on the cash resources of a company, it is not favorable for management. A key issue for a company to improve its operation efficiency is to identify the optimum inventory levels and thus minimize the cost tied up in inventories.

Inventory to Working Capital Formula

The inventory to working capital formula is as follows:

Inventory Working Capital Ratio = Inventory / Working capital

Inventory to Working Capital Calculation

For example, a company has $10,000 in working capital and $8,000 in inventory.

Working capital = 8,000 / 10,000 = 0.8

This means that $0.8 of a company’s fund is tied up in inventory for every dollar of working capital.

Managing your cash flow is vital to a business’s health. If you haven’t been paying attention to your cash flow, access the free 25 Ways to Improve Cash Flow whitepaper to learn how to can stay cash flow positive in tight economies. Click here to access your free guide!

Inventory to Working Capital Example

For example, John owns a business which manufactures electronic prototypes. He has been an electrical engineer for years and knows the operations of his business. But over time, John realized that he needs to know more about the financials of his business. Because he hopes to retire one day, he is becoming more serious about his personal financial welfare.

Recently, John has been familiarizing himself with his quickbooks. Now, John wants to perform inventory to working capital analysis. He collects necessary information and performs the following calculation:

John has $10,000 in working capital and $8,000 in inventory

Working Capital = $8,000 / $10,000 = 0.8

Although John is satisfied with this ratio, like any business owner, he would like to decrease inventory supplies. Now that John knows where he stands, completing this task can be simplified.

After some research, John is able to find a local supplier of many of his inventory items. Though slightly more expensive, John begins to use this vendor. He can increase his payout and put more money into his personal retirement account when he has decreased inventory . John sees the value of keeping track of his company finances, and vows to regularly update his records. For more ways to improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.

Inventory to Working capital

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Inventory to Working capital

Resources

For statistical information about industry financial ratios, please go to the following websites: www.bizstats.com and www.valueline.com.

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Inventory Cost

See Also:
How to Manage Inventory
Inventory Turnover Ratio Analysis
Days Inventory Outstanding Analysis
Inventory to Working Capital Analysis
Freight on Board (FOB)

Inventory Cost Definition

Defined as the total cost that a company experiences while holding inventoryinventory cost is often one of the most substantial factors in the success of a business. Inventory cost control has many facets, including financing, equipment, labor, protective measures, insurance, handling, obsolescence, losses by pilferage, and the opportunity cost of choosing to deal with inventory. These factors all combine to create the total cost of holding inventory.

Inventory Cost Explanation

Inventory cost, explained by each business owner with varying importance, plays a major role in the working capital requirements of a business. Based on the overall inventory needs, a company can can plan the cash flow cycles properly to avoid problems which may even cause the business to cease operations. This makes sense when one keeps in mind that perhaps the most common reason a business closes is lack of cash.

There are a variety of inventory cost methods to minimize expenditure. On the material side, a business can set up equipment, ranging from simple placement of items for optimal usage to accounting systems which serve as inventory management, which simplify and change based on the needs the business has for its inventory. In reference to processes, employees can be trained to use available resources to achieve maximum effect. When you understand the science of supply chain management, you can make sense of the most complicated of inventory projects. For smaller assignments, the average person can turn a catastrophe to a working system with a foundation of proper planning. Inventory can be as affordable or costly as the business and manager allow it to be.


Download The Know Your Economics Worksheet


Inventory Cost Formula

The inventory cost formula, summing total cost of inventory, is often referred to as inventory carrying rate.

Inventory Carrying Rate = (Inventory Costs / Inventory Value) + Opportunity Cost (as a percentage) + Insurance (as a percentage) + Taxes (as a percentage)

Inventory Cost Calculation

When one has the proper information, inventory cost calculations can be very simple.

Example:
If:
Inventory Costs = $5,000
Inventory Value = $50,000
Opportunity Cost = 10%
Insurance = 4%
Taxes = 7%

Inventory Carrying Rate = ($5,000 / $50,000) + 10% + 4% + 7% = 10% + 10% + 4% + 7% = 31%

Inventory Cost Example

For example, Stan is the warehouse manager for a distribution plant. His work has made him an expert in the science of managing inventory operations. Stan understands his work and enjoys doing it.

However, Stan wants to assemble inventory cost accounting figures. As the essence of the business, Stan makes sure to keep track of this value on a regular basis.

First, Stan calculates inventory costs:

If:
Equipment = $2,500
Labor = $1,500
Protective measures = $300
Handling = $500
Obsolescence = $100
Pilferage = $100

Then:
Inventory Cost = $2,500 + $1,500 + $300 + $500 + $100 + $100 = $5,000

Next, Stan finds the ratio of inventory costs to inventory value:

If:
Cost of Inventory = $5,000
Value of Inventory = $50,000

Then:
Inventory Cost / Inventory Value = $5,000 / $50,000 = 10%

Stan then does research to find the cost of opportunity, insurance, and taxes. These are found as a percentage:

Opportunity Cost = 10%
Insurance = 4%
Taxes = 7%

Finally, Stan adds these percentages together to finally find inventory carry rate:

Inventory Carrying Rate = 10% + 10% + 4% + 7% = 31%

Stan’s inventory carry rate has remained unchanged. Stan is happy about this. Therefore, he keeps constant research in the industry magazines, with professional contacts, and the newest products and services. As long as Stan maintains this research he can keep his warehouse running in peak condition.

If you want to find out more about how you could utilize your unit economics, then click here to download the Know Your Economics Worksheet.

inventory cost

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Collect Accounts Receivable

See Also:
Accounts Receivable
Accounts Receivable Collection Letter
Financial Ratios
Accounts Receivable Turnover
What is Factoring Receivables?
Accounts Receivable Turnover Analysis
Net 30 Credit Terms

Collect Accounts Receivable

Every company has them…past due and slow pay accounts. Here are some ways to help keep your cash coming in the door and collect accounts receivables.

Improve Accounts Receivable Collection and Invoicing

Commercial and industrial experience has proven the following percentages… Of ten new customers, six will pay on time, two will pay in 60 to 90 days and two will become collection problems.

Always watch your new sales. As money becomes tighter, you will receive one-time sales from firms that may be experiencing financial problems. While these customers will bounce from business to business, they need your close attention if you want to retain them. A useful management tool for collecting accounts receivable is the Flash Report.

Credit

Be familiar with your customers’ credit. Only extend credit to organizations you feel confident will pay you. Make sure you don’t have to write off your hard earned sales through bad debt!

Pay close attention to the credit terms you are offering your customers. One good way to collect accounts receivable (ar) is to do so before you deliver your product and structure your terms accordingly. An example of this would be a propane company in the winter months; nothing works better than to be paid prior to delivery.

Examples of accounts receivable payment terms:

For custom manufacturing companies:

50% before work begins, 40% before delivery and 10% after delivery

For wholesalers and retailers:

Depending on creditworthiness, 10 days net for companies with good credit, prior to delivery for companies with questionable credit or those that are past due.

Develop a minimum sales order that will require a credit check

Check three references on a new client

If payment history is greater than 60 days obtain supervisor approval

Perform the following steps when invoicing the customer:

  • Invoice within 24 to 48 hours after performing service
  • Review invoices for accuracy
  • Double check that everything has been billed
  • Note payment terms on the invoice
For more tips on how to optimize your accounts receivable, download your free A/R Checklist here.

Assign Responsibility for Accounts Receivable Collections

Use a dedicated collections individual. Then designate one person in your organization to be the accounts receivable collections representative, someone who can make the collection calls and stay on top of accounts receivable. There are some personality traits that you should look for when assigning this function. Some traits to look for: A professional presence, adept at working with and handling difficult people, skilled at follow up and well organized in order to document collection efforts.

You may want to pay your accounts receivable collections individual a commission as an incentive to keep accounts receivable collections current. Alternatively, you might consider paying a bonus at certain increments based on established criteria.

The goal is to work with delinquent companies and receive payment as quickly and cost effectively as possible!

For many companies, add accounts receivable collections to a current employee’s responsibilities as it should not be a full time commitment. If there is a legitimate reason the customer has not paid, then it’s best to get this taken care of early so as not to impact your cash flow for any longer than necessary. Never underestimate the impact of reminder and collection calls!

Accounts Receivable (AR) Collection by Telephone

Given the use of voice mail the effectiveness of phone calls are somewhat diminished. However, they are still an effective means of collection. The phone calls enable the credit manager to present their case to the debtor for immediate response. During the conversation you can determine whether the claim will be paid in full and when. This is the time to determine the reasons for non-payment.

We have put together the following three main reasons for non-payment:

  • Lack of funds. Most non-payments result from lack of funds.
  • Dispute. Discuss disputes to determine whether or not they are valid. Adjust the valid claim quickly and fairly, the non-valid claim exposed and immediate payment requested.
  • Refusal to pay. If it is refusal to pay, you must take third-party steps to enforce payment. Consider hiring a collections attorney.

Check out the following tips on phone collections:

  • Identify yourself and the company
  • Call the person in charge
  • Ask for the payment in full by a specific date
  • If the bill is in dispute, suggest a solution
  • Put it in writing if a solution is met
  • Set up a personal meeting with the client if the solution is not met

Download The A/R Checklist


Managing the Accounts Receivable Process

To quote Peter Drucker: You can’t manage it if you don’t measure it! The same holds true for collecting accounts receivable! So how do you measure your effectiveness in collecting accounts receivable?

Daily Sales Outstanding (DSO)

What is DSO?

DSO is the average of your accounts receivable. The numerical accuracy of the number is not as important as the trend. But blend an estimate of how long it takes to collect your accounts receivable. If you are making progress then it should be trending lower. First, calculate where you are today.

How do you calculate DSO?

Use the following formula to calculate DSO:

DSO = 365/ (Annual Credit Sales/ Average Accounts Receivable)

Commercial Collection Servicies

Hire a collection agency. Ways to find a reputable collection agency include referrals from other companies as well as professional firms and organizations with which your company does business. No matter how you receive the referral, be sure to ask the collection agency for customer references and call the references. Ask some of the following questions:

  • How responsive is the collection agency to your questions?
  • Do you have a report on the progress of your accounts promptly and in a format that is user friendly?
  • Do they remit proceeds quickly and accurately?
  • Can you resolve these issues quickly?

Final Comments

Review your internal process. Remember, collecting accounts receivable is an internal process as well! Before initiating collection calls, be sure your internal house is in order. It is vitally important that your cash applications are timely and done correctly. It’s extremely embarrassing and inefficient when you run into the following situation. Your collections representative conducts a collection call only to find that the customer has in fact paid the bill and the payment has been misapplied. Furthermore, a similar situation also exists when your employee makes a collection call when the payment was received 2 weeks earlier.

Accounts Receivable Collections

AR Collections should start with your cash applications function. Remember, your process here is critical. So follow it without exception. Further more, apply payments quickly and accurately. If you cannot identify a payment to an invoice, then call the customer in a timely manner to identify what is being paid. This is absolutely critical!

Issue invoices that make cash application quick and easy. If you have large volumes of invoices or are short staffed, automate this process. Then, have an organized and mechanical follow up of accounts at regular intervals in your systems. For instance, use 10,30 and 60 days past due.

Any program that permits three statements or a two to three month time lag before the first collection step is taken will result in a lower recovery ratio. Make collections update meetings a priority for the controller and collections person. At the meeting, review collection notes, progress and next steps.

Know the Cost of Past Due Accounts

If you cover your cash shortfalls with a line of credit, then consider that at an interest rate of 10% on your line, every $100,000 in past due accounts costs you $833 per month or $10,000 per year.

Train Your Customers to be Good Payers

Creating an accounts receivable collection process and following it consistently will allow you to accomplish this important goal.

For more ways to add value to your company, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.

collect accounts receivable

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Current Ratio Definition

See Also:
Balance Sheet
Current Assets
Current Liabilities
Working Capital Analysis
Quick Ratio Analysis
Net Cash

Current Ratio Definition

The current ratio definition, defined also as the working capital ratio, reveals company’s ability to meet its short-term maturing obligations. Values for the current ratio vary by company and industry. In theory, the larger the ratio is, the more liquid the business is. However, comparing to the industry average is a better way to judge the performance. Quick ratio, current ratio, and other terms are common measurements of cash in a company.

Current Ratio Explanation

Current ratios are a measure of a company’s ability to pay the current debt liabilities. For the lenders, current ratio is very helpful for them to determine whether a company has a sufficient level of liquidity to pay liabilities. They would prefer a high current ratio since it reduces their risk.

For the shareholders, current ratio is also important to them to discover the weakness in the financial position of a business. They would prefer a lower current ratio so that more of the company’s assets can be used for growing business. Although current ratio is an indicator of liquidity, investors should be aware that it can not give us the comprehensive information about company’s liquidity.

Every industry has its own norms of current ratio. The better way to evaluate it is to check a company’s current ratio against its industry average. More importantly, investors should look at the trend of the current ratio of the company, types of current assets the company has and how quickly these can be converted into cash to meet company’s current liabilities.


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Current Ratio Formula

Use the following formula to calculate current ratio:

Current ratio = Current assetsCurrent liabilities

Current Ratio Calculation

When calculated diligently, current assets represent cash and other assets that will be converted into cash within one year. It normally included cash, marketable securities, accounts receivable and inventories.

Current liabilities represent financial obligations that come due within one year. It normally included accounts payable, notes payable, short-term loans, current portion of term debt, accrued expenses and taxes.

For example, a business has $5,000 in current assets and $2,500 in current liabilities.

Current ratio = 5,000 / 2,500 = 2

This means that for every dollar in current liabilities, there is $2 in current assets.

Current Ratio Example

For example, Desmond has started a scrap metal recycling company called Scrapco. Desmond has made a comfortable living for himself by conducting business with accountability and professionalism in an industry where this is not always the case. Recently, the scrap metal market has experienced some distress and prices have varied much more than before. This has caused his cash stockpiles to vary within the market. As a result, Desmond is worried that he may not be able to meet obligations on the debt financing he has taken for his company equipment. This mainly processing machines for the commodities he receives from individuals to put onto the market.

Desmond decides to do a little research and finds out that this issue is a financial ratio called “current ratio”. He then extends his research to using search engines for the keyword “current ratio calculator“. Unsatisfied with the outcome, Desmond speaks to his accountant. His accountant performs the current ratio calculation below:

If:
Assets = $5,000
Liabilities = $2,500

Then:
Current ratio = 5,000 / 2,500 = 2

This means that for every dollar in current liabilities, there is $2 in current assets.

Conclusion

In conclusion, Desmond is happy to hear that he has little to worry about. He would like to increase his current ratio. But he comforted by where Scrapco stands. Furthermore, Desmond knows that lack of cash is one of the main reasons why businesses fail and resolves to decrease unnecessary expenditures and pay more attention to his cash holdings.

Current ratios are just another way of checking your economics or financials. If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

current ratio definition

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current ratio definition

Resources

For statistical information about industry financial ratios, please go to the following websites: www.bizstats.com and www.valueline.com.

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Covenant Definition

See Also:
Company Valuation
Coupon Rate Bond
Fixed Income Securities
How to Manage Your Banking Relationship
Long Term Debt
Non-Investment Grade Bonds
Par Value of a Bond

Covenant Definition

The covenant definition is a restrictive clause in a bond contract. The purpose of the clause is to protect the lender (the party that invests in the bond) by imposing restrictions on the borrower (the party that issues the bond). Furthermore, the covenant amounts to the lender agreeing to lend money to the borrower as long as certain financial performance criteria are met and maintained throughout the duration of the loan contract.

Convenant Criteria

Covenants may cover criteria including the following:

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covenant definition

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LEARN THE ART OF THE CFO