Looking at metrics for accounts payable, accounts receivable and working capital efficiency over time and against benchmarks can tell us if we are headed toward being cash strapped or if we can safely grow our business. They draw attention to payment and collection policies that might need closer investigation to keep us solvent and financially flexible.
The aim of the accounts payable/receivable game is to pay the bills at the last possible minute to still qualify for discounts and avoid penalties, while collecting the money as fast as practical to earn interest or dividends or just to pay accumulated bills. Remember, you are not the client's bank.
Strive for less than 14 days for accounts receivable and less than 20 for accounts payable.
Paying in full within 10 days typically earns a 2 percent discount, which is similar to getting 36 percent annual return on that money - a rate I dare say we can only dream about today. Taking advantage of all prompt-pay discounts helps bring the average payables turnover down; it's likely that the time it takes to pay bills will range from 10 to 29 days.
As for receivables, if it takes more than 14 days to collect, your own bills probably are going unpaid for two weeks. We mostly collect in five days - if we can't, our contract includes language giving us the right to pull off the job and find a client who will pay on time.
The final check is especially important. If it isn't paid on time, you need to react immediately, as it usually represents all your net profit. However, it may be the most difficult to collect. If you keep it small - no more than 5 percent of the overall price - it will have a lesser effect on your cash flow and your receivables turnover.
If your average receivables turnover is high, it could mean you are giving clients too much leverage by scheduling fewer, larger payments rather than a number of smaller ones. It could also mean you need to improve your closeout procedure - and the language in your contract - to complete the punch list, enforce final payment and transition into the warranty phase.To ensure on-time receivables, try these tips.
- Hand deliver and pick up progress billings.
- Leave no more than 5 percent of the total price as the last payment - none of these 1/3, 1/3 and 1/3 draw schedules.
- Don't make change orders part of the last payment of the job. Instead, collect on change orders in full at the time of signing.
- Finally, state an interest rate for late payments in your contract so you can at least recoup some money for the inconvenience of acting like their bank.
Practically, we should look at current assets as those we could convert to cash within one year or less and current liabilities as bills that are due in up to one year (not that you would wait that long on the lumber bill). Your current ratio should always be greater than 1.0, indicating you have positive working capital. This is the money you use to pay bills, buy capital equipment, hire staff and offer benefits.
Without working capital, you are out of gas for your business's engine. Indisputable failure is often the result.
Watching your current ratio gives you a heads-up on cash shortages. An early warning might lead you to take out a line of credit from a bank, convert short-term loans to long-term loans, or decide to forego a purchase or hire. Strive for a 1.4 or greater current ratio.
To determine how much working capital you should have on hand, multiply your average daily volume by the number of days that you are "floating" clients by acting like their bank. This target ensures you have enough money on hand to pay bills promptly and take advantage of prompt-pay or 10-day discounts.
For example: Let's say your company has an accounts receivable turnover of 14 days and annual volume of $1 million. Your average daily volume is $2,740 ($1 million divided by the 365 days of the year). Your working capital target would be $2,740 x [40 - (30-14)], or $2,740 x 24, which is $65,750. If you had faster collections and accounts receivable turnover of 7 days, your target would be reduced to $46,580.
Thus, the slower you are collecting - and sometimes you know certain clients or a particular season will be slower than normal - the larger your target working capital needs. Don't overspend in the face of obvious working capital binds.
Working capital is also the growth engine. It comes from profits, loans, injections of capital via stock, or conversion of short-term loans to long term. When we choose to grow, we need to make sure we are properly capitalized as well as able to sell and produce the extra work. My rule of thumb is to grow no more than 12 times working capital as a percentage of annual sales or 10 times working capital in dollars.
As an example: You have current assets of $100,000 and current liabilities of $80,000, giving you a 1.25 current ratio and $20,000 of working capital. Your volume is $1 million, so your working capital is just 2 percent of sales. Using the percentage formula, you should grow no more than 12x2 percent, or 24 percent ($240,000), in the coming year. Using the dollar formula, you should grow no more than $20,000 x 10, or $200,000. Use the lower figure to be safe, fairly confident that you won't outgrow your cash and credit availability.
If you have negative working capital, growth usually worsens the situation. Correct what is wrong with your finances, pricing and client selection before moving forward on increasing sales. More people, more stuff, and desperation to reach sales goals make for a lethal combination. Working capital is the most important thing to look at when profitability is low, sporadic or very seasonal, because cash is like gas. Run out and you stop dead!
Payables turnover: The average time in days a bill goes unpaid
To calculate: Divide month's end accounts payable by annual sales, then multiply by 365
Benchmark: Less than 20 days
Receivables turnover: The average time in days a bill goes uncollected
To calculate: Divide accounts receivable by annual sales, then multiply by 365
Benchmark: Less than 14 days
Working capital: Current assets minus current liabilities
Benchmark: Average volume per day multiplied by [(30 days plus 10 days for non-discount purchases) minus (30 days minus accounts receivables turnover in days)]
Current ratio: Current assets divided by current liabilities
Benchmark: 1.4 or greater