Working Trade Capital Formula
In his latest blog for accountingcpd.net author John Mardle looks how the Working Trade Capital formula can undermine accountants and affect funding.
By John Mardle
Why does the Trade Working Capital formula (DIO plus DSO less DPO) undermine accountants, credit agencies and the financial accounts therefore causing obstacles to funding?
The standard, but not the only, formula for working Capital is current assets less current liabilities and when describing the trade working capital element the terms are calculated in days as follows:
Days Inventory Held (DIH) = Inventory/ (Cost of Sales/365)
Days Sales Outstanding (DSO) = Receivables/ (Sales/365)
Days Payable Outstanding (DPO) = Payables/ (Cost of Sales/365)
Therefore the Cash Conversion Cycle (CCC) = DSO + DIH – DPO. However from the above formulae one can deduce that each one has its subjective element.
As an example all formulae use the rule of 365 days in a year. However every business has a ‘unique year’. They could have year ends at any point in the calendar year. The company may be very seasonal i.e. a holiday camp company or Christmas driven company. A company may have commenced or ceased business during the year, had to close the business due to a catastrophic event, say flooding, or moved premises all of which may have decreased the number of days to trade.
Two of the formulae use cost of sales which itself can be very subjective. For instance in the construction sector work in progress is generated in many cases on the back of a method called percentage of completion (POC) where the percentage of the estimate cost to complete is used to generate the revenue figure which itself generates a profit equivalent to the gross margin percentage estimated on the contract. Thus 50% cost completed generates 50% revenues and at 10% net margin generates 90% cost of sales on that revenue recognised. All of this is very subjective.
Finally the DSO figure could be the most reliable however many systems are found to be wanting when attempting to even compare month on month or quarter on quarter figures as the month of February only has 28 days (or 29 in a leap year) and indeed at Holiday times like Easter and particularly Christmas the number of trading days in any given month i.e. December/January in the case of Christmas could have up to 12 trading days ‘missing’.
However, if one consistently reports the exact same results using the exact same formulae then any comparison can be made say, year on year.
The new approach is not only to take account of the constraints of the formulae above but also to deliver consistently more accurate results by determining such working capital formulae by using ‘working capital drivers’ that are driven down into the bowels of the organisation and truly reflect the KPI’s around each of the trade working capital metrics. For instance DPO (Days Purchases outstanding) may require metrics that reflect goods returned notes where the quality is suspect, incorrect goods supplied or where the goods/services are non-compliant in other ways.
One still cannot compare company to company in either the DSO or DPO areas as each company may have totally different terms and conditions of sale and purchase. These company’s’ could even be trading in different countries where terms and conditions regarding settlement are different (Scandinavian countries typically have payment terms of 14 days whereas as you move into Southern Europe it moves to 90 days) and if they were even in the same country they may be impacted by specific trading conditions that affect one company more than the other i.e. the use of transport to move goods by ferry or air by one company due its location in a remote area may be impacted by weather conditions or natural disasters like flooding, tsunami, earthquake, erupting volcano etc.
The challenge is therefore to deliver trade working capital drivers that reflect the individuality of each company.