Working capital is a financial metric that can be calculated out of the balance sheet and measures the liquidity of the business.
Working Capital Formula
Working capital can be calculated by subtracting current liabilities from the current assets.
Working Capital = Current Assets – Current Liabilities
But what are the components of this formula for a retail business? Let’s break it down.
The current assets for a retail business will include:
- Cash: Money paid by customers who purchased your products.
- Accounts Receivables: Money that is going to be received from customers who ordered but still haven’t paid.
- Inventory: Merchandise in stores and warehouse that can be liquidated within a year
It should be noted that, while accounting for inventory, you will not account for it at the normal cost price. You have to apply provisions that will reflect the real liquidation value of the merchandise if you had to sell it quickly.
For example if you have products that cost 100$ but have been on your system for more than 6 months, most probably you will not be able to liquidate them at 100$. So 100$ can be 75$ after 6 months in your stores/warehouses, and then 50$ after 9 months, and so on.
You will have set provision norms to be applied every month to your outstanding inventory. All this has to be reflected in your balance sheet and in your working capital calculation. Also the difference between the cost and the net realizable value, if negative, will be reflected as a loss in your P&L.
The current liabilities for a retail business will include:
- Accounts Payable: Money that is yet to be paid to suppliers for received or ordered invoiced shipments. Can also include invoices for admin expenses, such as electricity or municipality fees that are yet to be paid but have been invoiced.
- Short-term Borrowings: Any debt that has to be paid back within a year
- Accrued Liabilities: Any bills that have to be paid within the year and have not been accounted for under accounts payables, because invoices have not been received yet; e.g. can be confirmed bindable orders from suppliers that are going to be received and invoiced upon receipt. This can also include accrued pension liabilities for employees or accrued payroll taxes
What Is The Importance of Working Capital?
Working Capital measures the liquidity of a business, or, in plain english, how fast the business can generate cash if needed.
Read Also: Cash Flow Management for Retail & Ecommerce
This is important, because if the company doesn’t have enough cash flow and cannot liquidate assets fast enough to pay its upcoming bills, it will have to resort to expensive measures to finance its operations, such as taking more debt.
If it was not able to raise money, either through debt or through investors, It might reach a state where it will be completely paralyzed and has to file for bankruptcy.
Working Capital Requirements for Retail
Retail typically requires a low working capital, due to the fact that customers pay on the spot and retailers pay their suppliers on a delayed basis. For big retailers, who can negotiate favorable payment terms with suppliers, they can sell the product before even paying for it.
If they needed more cash quickly, retailers can create clearance events in/out of stores and liquidate easily.
Nevertheless; it is still very important for you as a retail manager or small business owner to not only look at the P&L, but to monitor all your financial statements which include P&L, balance sheet and cash flow statements.
Read More: P&L Management
Unexpected Factors Affecting Working Capital
There are many different unexpected events that can happen and affect working capital. These could include:
- Currency devaluation
- Bankruptcy or default of one or more of your customers
- Sudden call on your loans by the bank
- Inventory damage or theft (If not fully covered by insurance)
- Lawsuits/ claims/ Tax penalties or any sudden legal expense
- Update (7 April 2020): A global pandemic!
Many Egyptian businesses, entered into a very bad cash crunch due to the devaluation of the Egyptian Pound in 2016.
What happened was that they ordered already their products from, say, European suppliers, for which they were invoiced for in Euros. Let’s say 100,000 Euro was their accounts payable to their suppliers, to be paid over 3 months.
They then sold the products to their customers in Egyptian Pounds. They typically don’t collect cash immediately from their customers, but have payment terms that allow for some delay (Accounts Receivable).
Overnight the Egyptian government floated the Egyptian Pound and its value was almost halved. So now all the money that they will collect from their customers will not be sufficient to pay their suppliers, and so their current liabilities will be higher than their current assets; i.e negative working capital.
The only way to solve this was to borrow money, but, due to the devaluation and skyrocketing inflation the interest on loans were at 20%. This alone can wipe away the profit margins in many industries.
As a business manager and small business owner you need to be aware of all the different financial metrics & statements for your business. You should also be aware about the risks associated any of these metrics and how to mitigate such risks.
You might want to look at the payment terms your are giving to your customers, and whether or not changing such terms to be more favorable for you will affect your sales. You might also want to go back and check if you have a solid insurance policy in place.
Furthermore, if you are dealing with international trade, currency is always a risk factor.
Basically, go through all the factors that might pose a risk to your business, and then figure out how to mitigate each one of them.
More often than not, the risk is not in the business model itself, but in the business environment around it.Tweet
Read more on Retail Financials
Retailer & Founder of Retail Dogma, Inc.
Rasha has 12 years of retail & ecommerce experience. She has started an ecommerce business in 2008, and later worked at H&M, Bath & Body Works, Victoria’s Secret and Landmark Group. She has lived in 4 different countries, speaks 3 different languages and holds a master’s degree in Strategic Management & Marketing.