2 finance formulas every small business owner should know
Two finance formulas to use when managing small business cash flow – one to calculate working capital and another your cash conversion cycle.
At a glance
Here’s a snapshot of the article’s insights:
- Aussie small businesses are in a growth mindset, with 85 per cent anticipating growth over the next year.
- Working capital is a useful metric to judge the financial position of a business gearing up for growth.
- Another metric is the cash conversion cycle, which calculates the time it takes for money that leaves a business to return again – the shorter the cycle, the better a business’s cash flow.
As the new year begins, Australian small businesses are making plans to grow. In fact, 85 per cent of business owners anticipate growth over the next 12 months.*
The top three anticipated sources of growth are new clients or customers from referrals, more business from existing clients and customers, and new products or services. This focus on their business’s growth – and the specific paths they can follow to achieve it – puts owners in prime position to thrive in 2023.
But growth doesn’t occur without keeping an eye on business finances – and that’s where knowing a business’s working capital and cash conversion cycle come into play.
How working capital can inspire growth
In general terms, working capital is an assessment of a business’s ability to cover upcoming costs.
In a perfect world, a business would be paid for its products sold or services delivered without any delay. With no time lag between money going out and money coming in, there would be no need to hold extra funds to tide the business over to the next sale or to cover expenses such as wages, rent and tax.
In reality, however, every business needs a pool of cash on hand to bridge that cash flow gap. This pool is the money available to fund day-to-day operations, and is known as working capital. Working capital can play an essential role in helping business owners achieve their growth goals.
How to calculate working capital
Use the following formula to calculate working capital:
current assets – current liabilities = working capital
Current assets include anything a business owns or has a claim on, that can be rapidly turned into cash – think inventory and accounts receivable. Current liabilities are obligations that will soon fall due – think short-term debt and accounts payable. (Note: ‘current’ usually means due within one year).
As an example, imagine a small business owner with $20,000 in cash and $50,000 in stock, and with debtors owing a total of $50,000 due within the next month. The value of the business’s current assets amounts to $120,000.
Let’s say that the sum of short-term expenses and money owed to creditors – including accounts payable, payroll, taxes, monthly subscriptions and rent – comes to $100,000.
Using the working capital formula, $120,000 worth of assets and $100,000 worth of liabilities leaves the business owner with working capital of $20,000. That’s $20,000 on hand to cover gaps in cash flow and any unexpected expenses.
How to calculate the cash conversion cycle
Another way of gaining insight into a business’s cash flow position is to calculate how long it takes, on average, for the money that goes out to come back in. This is known as the operating cycle or cash conversion cycle.
Calculating a business’s cash conversion cycle requires three different values:
- Inventory days: How long stock sits on the shelf, or how long a business has to pay for labour and materials to create a saleable product.
- Debtor days: How long it takes to collect payment from clients or customers.
- Creditor days: How long a business can hold on to cash before it must pay suppliers.
Then, it’s a matter of popping those values into the following formula:
(inventory days + debtor days) – creditor days = cash conversion cycle
If the owner of children’s toy store has their stock sitting on shelves for an average of 55 days, takes 45 days on average to collect payments from customers, and must pay their suppliers every 30 days, the cash conversion cycle amounts to:
(55 inventory days + 45 debtor days) – 30 creditor days = 70 days
The toy retailer would therefore wait 70 days for their outlays to turn back into cash.
The ultimate aim is to reduce the cash conversion cycle, which can be done by encouraging clients to pay back invoices sooner. Doing so can help put small business owners – such as the toy store owner – in a place that’s primed for growth, and better equip them for the unexpected, or new moves, in 2023.
*Prospa x YouGov SME Sentiment survey, November 2022